In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
CCT Fortis Holdings Limited (HKG:138) is currently trading at a trailing P/E of 5.4x, which is lower than the industry average of 9.7x. While this makes 138 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
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Demystifying the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 138
Price-Earnings Ratio = Price per share ÷ Earnings per share
138 Price-Earnings Ratio = HK$0.73 ÷ HK$0.136 = 5.4x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 138, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 5.4, 138’s P/E is lower than its industry peers (9.7). This implies that investors are undervaluing each dollar of 138’s earnings. This multiple is a median of profitable companies of 24 Capital Markets companies in HK including Freeman FinTech, Oriental Explorer Holdings and Emperor Capital Group. One could put it like this: the market is pricing 138 as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, 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 138, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 138, 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 138 to are fairly valued by the market. If this is violated, 138’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to 138. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 urge you to complete your research by taking a look at the following: