Why Newborn Town Inc.'s (HKG:9911) High P/E Ratio Isn't Necessarily A Bad Thing

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use Newborn Town Inc.'s (HKG:9911) P/E ratio to inform your assessment of the investment opportunity. What is Newborn Town's P/E ratio? Well, based on the last twelve months it is 18.95. That corresponds to an earnings yield of approximately 5.3%.

See our latest analysis for Newborn Town

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Newborn Town:

P/E of 18.95 = CN¥1.554 ÷ CN¥0.082 (Based on the trailing twelve months to December 2019.)

(Note: the above calculation uses the share price in the reporting currency, namely CNY and the calculation results may not be precise due to rounding.)

Is A High P/E Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each CN¥1 the company has earned over the last year. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price'.

How Does Newborn Town's P/E Ratio Compare To Its Peers?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that Newborn Town has a higher P/E than the average (15.3) P/E for companies in the software industry.

That means that the market expects Newborn Town will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So further research is always essential. I often monitor director buying and selling.

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. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

Most would be impressed by Newborn Town earnings growth of 19% in the last year. And it has bolstered its earnings per share by 11% per year over the last five years. So one might expect an above average P/E ratio.

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

The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Newborn Town's Balance Sheet

With net cash of CN¥315m, Newborn Town has a very strong balance sheet, which may be important for its business. Having said that, at 20% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Verdict On Newborn Town's P/E Ratio

Newborn Town trades on a P/E ratio of 19.0, which is above its market average of 9.1. Its strong balance sheet gives the company plenty of resources for extra growth, and it has already proven it can grow. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.

Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.

Of course you might be able to find a better stock than Newborn Town. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.