World Precision Machinery Limited (SGX:B49) is trading with a trailing P/E of 9.9x, which is lower than the industry average of 11.1x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for World Precision Machinery

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 B49

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

B49 Price-Earnings Ratio = CN¥0.91 ÷ CN¥0.092 = 9.9x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as B49, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 9.9x, B49’s P/E is lower than its industry peers (11.1x). This implies that investors are undervaluing each dollar of B49’s earnings. Therefore, according to this analysis, B49 is an under-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to buy B49 immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to B49. 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 B49, 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 B49 to are fairly valued by the market. If this is violated, B49’s P/E may be lower than its peers as they are actually overvalued by investors.

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.