This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.
China Financial Services Holdings Limited (HKG:605) is currently trading at a trailing P/E of 8x, which is higher than the industry average of 8x. 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
View our latest analysis for China Financial Services Holdings
Demystifying 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 605
Price-Earnings Ratio = Price per share ÷ Earnings per share
605 Price-Earnings Ratio = HK$0.57 ÷ HK$0.0709 = 8x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 605, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do.
Assumptions to watch out for
While our conclusion might prompt you to sell your 605 shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 605, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 605, 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 605 to are fairly valued by the market. If this is violated, 605’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 605 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 urge you to complete your research by taking a look at the following: