This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at China Water Affairs Group Limited's (HKG:855) P/E ratio and reflect on what it tells us about the company's share price. China Water Affairs Group has a price to earnings ratio of 10.14, based on the last twelve months. That means that at current prices, buyers pay HK$10.14 for every HK$1 in trailing yearly profits.

Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!

View our latest analysis for China Water Affairs Group

How Do I Calculate China Water Affairs Group's Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for China Water Affairs Group:

P/E of 10.14 = HK$7.89 ÷ HK$0.78 (Based on the trailing twelve months to September 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 Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.

China Water Affairs Group increased earnings per share by an impressive 23% over the last twelve months. And it has bolstered its earnings per share by 30% per year over the last five years. This could arguably justify a relatively high P/E ratio.

How Does China Water Affairs Group's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (7.5) for companies in the water utilities industry is lower than China Water Affairs Group's P/E.

Its relatively high P/E ratio indicates that China Water Affairs Group shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

Remember: P/E Ratios Don't Consider The Balance Sheet

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

How Does China Water Affairs Group's Debt Impact Its P/E Ratio?

China Water Affairs Group has net debt worth 66% of its market capitalization. This is a reasonably significant level of debt -- all else being equal you'd expect a much lower P/E than if it had net cash.

The Verdict On China Water Affairs Group's P/E Ratio

China Water Affairs Group's P/E is 10.1 which is below average (11.3) in the HK market. The company has a meaningful amount of debt on the balance sheet, but that should not eclipse the solid earnings growth. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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 report on the analyst consensus forecasts could help you make a master move on this stock.

But note: China Water Affairs Group may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

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.