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Here’s How P/E Ratios Can Help Us Understand China Petroleum & Chemical Corporation (HKG:386)

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 China Petroleum & Chemical Corporation’s (HKG:386) P/E ratio to inform your assessment of the investment opportunity. China Petroleum & Chemical has a price to earnings ratio of 8.99, based on the last twelve months. That corresponds to an earnings yield of approximately 11%.

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How Do You Calculate China Petroleum & Chemical’s P/E Ratio?

The formula for price to earnings is:

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

Or for China Petroleum & Chemical:

P/E of 8.99 = CN¥5.35 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.60 (Based on the year to September 2018.)

Is A High P/E 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about 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. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.

China Petroleum & Chemical increased earnings per share by a whopping 29% last year. And it has improved its earnings per share by 31% per year over the last three years. With that performance, I would expect it to have an above average P/E ratio. In contrast, EPS has decreased by 2.4%, annually, over 5 years.

How Does China Petroleum & Chemical’s P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (10.7) for companies in the oil and gas industry is higher than China Petroleum & Chemical’s P/E.

SEHK:386 PE PEG Gauge January 23rd 19
SEHK:386 PE PEG Gauge January 23rd 19

Its relatively low P/E ratio indicates that China Petroleum & Chemical shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.

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

The ‘Price’ in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining 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).

How Does China Petroleum & Chemical’s Debt Impact Its P/E Ratio?

China Petroleum & Chemical has net cash of CN¥39b. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.

The Verdict On China Petroleum & Chemical’s P/E Ratio

China Petroleum & Chemical has a P/E of 9. That’s below the average in the HK market, which is 10.3. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. The below average P/E ratio suggests that market participants don’t believe the strong growth will continue.

When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. 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.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.