Asia Enterprises Holding Limited (SGX:A55) is trading with a trailing P/E of 42.9x, which is higher than the industry average of 22.4x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, 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 Asia Enterprises Holding

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 A55

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

A55 Price-Earnings Ratio = SGD0.18 ÷ SGD0.004 = 42.9x

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 A55, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. A55’s P/E of 42.9x is higher than its industry peers (22.4x), which implies that each dollar of A55’s earnings is being overvalued by investors. As such, our analysis shows that A55 represents an over-priced stock.

Assumptions to watch out for

However, before you rush out to sell your A55 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 A55, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with A55, 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 A55 to are fairly valued by the market. If this does not hold true, A55’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

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 A55. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. 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 highly recommend you to complete your research by taking a look at the following: