In This Article:
I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Bank of Chongqing Co Ltd (HKG:1963) is trading with a trailing P/E of 3.3x, which is lower than the industry average of 5.9x. While 1963 might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
View our latest analysis for Bank of Chongqing
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for relative valuation. 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 1963
Price-Earnings Ratio = Price per share ÷ Earnings per share
1963 Price-Earnings Ratio = CN¥4.01 ÷ CN¥1.199 = 3.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 1963, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since 1963’s P/E of 3.3 is lower than its industry peers (5.9), it means that investors are paying less for each dollar of 1963’s earnings. This multiple is a median of profitable companies of 24 Banks companies in HK including Shengjing Bank, Harbin Bank and Chongqing Rural Commercial Bank. You can think of it like this: the market is suggesting that 1963 is a weaker business than the average comparable company.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 1963, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 1963, 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 1963 to are fairly valued by the market. If this is violated, 1963’s P/E may be lower than its peers as they are actually overvalued by investors.
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 add more of 1963 to your portfolio. 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: