The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use AK Medical Holdings Limited's (HKG:1789) P/E ratio to inform your assessment of the investment opportunity. What is AK Medical Holdings's P/E ratio? Well, based on the last twelve months it is 33.5. That is equivalent to an earnings yield of about 3.0%.

See our latest analysis for AK Medical Holdings

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)

Or for AK Medical Holdings:

P/E of 33.5 = CN¥4.68 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.14 (Based on the year to December 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each HK$1 the company has earned over the last year. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

How Does AK Medical Holdings's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that AK Medical Holdings has a higher P/E than the average (14.8) P/E for companies in the medical equipment industry.

That means that the market expects AK Medical Holdings will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.

AK Medical Holdings maintained roughly steady earnings over the last twelve months. But it has grown its earnings per share by 15% per year over the last five years.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).

AK Medical Holdings's Balance Sheet

Since AK Medical Holdings holds net cash of CN¥459m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Verdict On AK Medical Holdings's P/E Ratio

AK Medical Holdings's P/E is 33.5 which is way above average (9.9) in its market. EPS was up modestly better over the last twelve months. And the net cash position provides the company with multiple options. The high P/E suggests the market thinks further growth will come.

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine.' So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

You might be able to find a better buy than AK Medical Holdings. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.