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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at Wonderful Sky Financial Group Holdings Limited's (HKG:1260) P/E ratio and reflect on what it tells us about the company's share price. What is Wonderful Sky Financial Group Holdings's P/E ratio? Well, based on the last twelve months it is 10.32. That corresponds to an earnings yield of approximately 9.7%.

See our latest analysis for Wonderful Sky Financial Group Holdings

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

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

Or for Wonderful Sky Financial Group Holdings:

P/E of 10.32 = HK$1.28 ÷ HK$0.12 (Based on the year 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 a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

How Growth Rates Impact P/E Ratios

If earnings fall then in the future the 'E' will be lower. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.

Wonderful Sky Financial Group Holdings's earnings per share fell by 33% in the last twelve months. But it has grown its earnings per share by 1.0% per year over the last five years. And it has shrunk its earnings per share by 16% per year over the last three years. This growth rate might warrant a low P/E ratio.

Does Wonderful Sky Financial Group Holdings Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see Wonderful Sky Financial Group Holdings has a lower P/E than the average (16) in the media industry classification.

This suggests that market participants think Wonderful Sky Financial Group Holdings will underperform other companies in its industry. Since the market seems unimpressed with Wonderful Sky Financial Group Holdings, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

Wonderful Sky Financial Group Holdings's Balance Sheet

Wonderful Sky Financial Group Holdings has net cash of HK$471m. This is fairly high at 31% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.

The Verdict On Wonderful Sky Financial Group Holdings's P/E Ratio

Wonderful Sky Financial Group Holdings has a P/E of 10.3. That's below the average in the HK market, which is 12. Falling earnings per share are likely to be keeping potential buyers away, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there's real potential that the low P/E could eventually indicate undervaluation.

Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. Although we don't have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

But note: Wonderful Sky Financial Group Holdings 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 [email protected]. 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.