This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.

Cteh Inc (HKG:1620) trades with a trailing P/E of 23.4, which is higher than the industry average of 16.2. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.

See our latest analysis for Cteh

What you need to know about the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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 1620

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

1620 Price-Earnings Ratio = HK$0.23 ÷ HK$0.00969 = 23.4x

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 1620, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 23.4, 1620’s P/E is higher than its industry peers (16.2). This implies that investors are overvaluing each dollar of 1620’s earnings. This multiple is a median of profitable companies of 25 Hospitality companies in HK including Shun Ho Holdings, Shun Ho Property Investments and Macau Legend Development. You could think of it like this: the market is pricing 1620 as if it is a stronger company than the average of its industry group.

A few caveats

However, it is important to note that our examination of the stock is based on certain assumptions. The first is that our “similar companies” are actually similar to 1620. If not, the difference in P/E might be a result of other factors. For example, Cteh Inc could be growing more quickly than the companies we’re comparing it with. In that case it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with 1620 are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.

What this means for you:

You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to 1620. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following: