Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Kunming Dianchi Water Treatment Co., Ltd.'s (HKG:3768) P/E ratio to inform your assessment of the investment opportunity. What is Kunming Dianchi Water Treatment's P/E ratio? Well, based on the last twelve months it is 5.70. That means that at current prices, buyers pay HK$5.70 for every HK$1 in trailing yearly profits.

Check out our latest analysis for Kunming Dianchi Water Treatment

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for Kunming Dianchi Water Treatment:

P/E of 5.70 = HK$2.02 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$0.35 (Based on the trailing twelve months to June 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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 Does Kunming Dianchi Water Treatment's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (5.7) for companies in the water utilities industry is roughly the same as Kunming Dianchi Water Treatment's P/E.

That indicates that the market expects Kunming Dianchi Water Treatment will perform roughly in line with other companies in its industry. So if Kunming Dianchi Water Treatment actually outperforms its peers going forward, that should be a positive for the share price. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

Kunming Dianchi Water Treatment increased earnings per share by an impressive 17% over the last twelve months. And its annual EPS growth rate over 5 years is 3.4%. This could arguably justify a relatively high P/E ratio.

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. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

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.

So What Does Kunming Dianchi Water Treatment's Balance Sheet Tell Us?

Kunming Dianchi Water Treatment's net debt is considerable, at 118% of its market cap. This is a relatively high level of debt, so the stock probably deserves a relatively low P/E ratio. Keep that in mind when comparing it to other companies.

The Verdict On Kunming Dianchi Water Treatment's P/E Ratio

Kunming Dianchi Water Treatment's P/E is 5.7 which is below average (10.2) in the HK market. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.

Investors should be looking to buy stocks that the market is wrong about. 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. Although we don't have analyst forecasts you might want to assess this data-rich visualization of earnings, revenue and cash flow.

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.

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.

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. Thank you for reading.