The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about the link between company’s fundamentals and stock market performance.

Li Ning Company Limited (HKG:2331) trades with a trailing P/E of 32.9x, which is higher than the industry average of 11.2x. While 2331 might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.

Check out our latest analysis for Li Ning

What you need to know about the P/E ratio

The P/E ratio is one of many ratios used in relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for 2331

Price-Earnings Ratio = Price per share ÷ Earnings per share

2331 Price-Earnings Ratio = CN¥7.06 ÷ CN¥0.215 = 32.9x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 2331, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 2331’s P/E of 32.9x is higher than its industry peers (11.2x), which implies that each dollar of 2331’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Luxury companies in HK including Hosa International, Victory City International Holdings and Embry Holdings. Therefore, according to this analysis, 2331 is an over-priced stock.

A few caveats

However, before you rush out to sell your 2331 shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to 2331, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 2331, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 2331 to are fairly valued by the market. If this does not hold, there is a possibility that 2331’s P/E is lower because our peer group is overvalued by the market.