Valuetronics Holdings Limited (SGX:BN2) is trading with a trailing P/E of 12.2x, which is lower than the industry average of 12.3x. While BN2 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 Valuetronics Holdings

Demystifying the P/E ratio

P/E is a popular ratio used for relative valuation. 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 BN2

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

BN2 Price-Earnings Ratio = HK$5.82 ÷ HK$0.476 = 12.2x

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 BN2, 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. BN2’s P/E of 12.2x is lower than its industry peers (12.3x), which implies that each dollar of BN2’s earnings is being undervalued by investors. As such, our analysis shows that BN2 represents an under-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to buy BN2 immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to BN2. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with BN2, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing BN2 to are fairly valued by the market. If this does not hold true, BN2’s lower P/E ratio may be because firms in our peer group are 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.