ANTA Sports Products Limited (SEHK:2020) is currently trading at a trailing P/E of 27.3x, which is higher than the industry average of 14.9x. While this makes 2020 appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for ANTA Sports Products

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for 2020

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

2020 Price-Earnings Ratio = CN¥29.03 ÷ CN¥1.063 = 27.3x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 2020, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since 2020’s P/E of 27.3x is higher than its industry peers (14.9x), it means that investors are paying more than they should for each dollar of 2020’s earnings. As such, our analysis shows that 2020 represents an over-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that 2020 should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to 2020. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with 2020, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing 2020 to are fairly valued by the market. If this does not hold, there is a possibility that 2020’s P/E is lower because our peer group is overvalued by the market.

To help readers see pass 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.