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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use Nissin Foods Company Limited's (HKG:1475) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Nissin Foods's P/E ratio is 31.10. In other words, at today's prices, investors are paying HK$31.10 for every HK$1 in prior year profit.
Check out our latest analysis for Nissin Foods
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Nissin Foods:
P/E of 31.10 = HK$7.07 ÷ HK$0.23 (Based on the year to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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.
Does Nissin Foods Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (14.5) for companies in the food industry is lower than Nissin Foods's P/E.
Nissin Foods's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. 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. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Nissin Foods's earnings per share grew by -9.7% in the last twelve months. And it has improved its earnings per share by 21% per year over the last three years. In contrast, EPS has decreased by 1.2%, annually, over 5 years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).