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Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. We’ll apply a basic P/E ratio analysis to China Life Insurance Company Limited’s (HKG:2628), to help you decide if the stock is worth further research. China Life Insurance has a P/E ratio of 22.91, based on the last twelve months. That is equivalent to an earnings yield of about 4.4%.
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share (in the reporting currency) Ă· Earnings per Share (EPS)
Or for China Life Insurance:
P/E of 22.91 = CNÂ„19.04 (Note: this is the share price in the reporting currency, namely, CNY ) Ă· CNÂ„0.83 (Based on the trailing twelve months to March 2019.)
A higher P/E ratio means that investors are paying a higher price for each HK$1 of company earnings. 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.
Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. That means unless the share price falls, the P/E will increase in a few years. Then, a higher P/E might scare off shareholders, pushing the share price down.
China Life Insurance shrunk earnings per share by 41% over the last year. But EPS is up 1.4% over the last 5 years. And it has shrunk its earnings per share by 4.9% per year over the last three years. This growth rate might warrant a low P/E ratio.
We can get an indication of market expectations by looking at the P/E ratio. As you can see below, China Life Insurance has a higher P/E than the average company (14.5) in the insurance industry.
That means that the market expects China Life Insurance will outperform other companies in its industry. Clearly the market expects growth, but it isn’t guaranteed. So further research is always essential. I often monitor director buying and selling.
Don’t forget that the P/E ratio considers market capitalization. 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 spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
China Life Insurance has net cash of CNÂ„146b. This is fairly high at 19% 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.
China Life Insurance’s P/E is 22.9 which is above average (12) in the HK market. The recent drop in earnings per share might keep value investors away, but the net cash position means the company has time to improve: and the high P/E suggests the market thinks it will.