AK Medical Holdings Limited (SEHK:1789) trades with a trailing P/E of 28.3x, which is higher than the industry average of 26x. While 1789 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 explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for AK Medical Holdings
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 1789
Price-Earnings Ratio = Price per share ÷ Earnings per share
1789 Price-Earnings Ratio = CN¥3.55 ÷ CN¥0.126 = 28.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 1789, 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. 1789’s P/E of 28.3x is higher than its industry peers (26x), which implies that each dollar of 1789’s earnings is being overvalued by investors. As such, our analysis shows that 1789 represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that 1789 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 1789. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with 1789, 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 1789 to are fairly valued by the market. If this does not hold, there is a possibility that 1789’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in 1789. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.