In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
China Grand Pharmaceutical and Healthcare Holdings Limited (HKG:512) is trading with a trailing P/E of 19.7, which is higher than the industry average of 15.6. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
View our latest analysis for China Grand Pharmaceutical and Healthcare Holdings
Breaking down the Price-Earnings ratio
The P/E ratio is one of many ratios used in 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 512
Price-Earnings Ratio = Price per share ÷ Earnings per share
512 Price-Earnings Ratio = HK$4.95 ÷ HK$0.252 = 19.7x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 512, 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. At 19.7, 512’s P/E is higher than its industry peers (15.6). This implies that investors are overvaluing each dollar of 512’s earnings. This multiple is a median of profitable companies of 24 Pharmaceuticals companies in HK including Jilin Province Huinan Changlong Bio-pharmacy, China Health Group and Shandong Xinhua Pharmaceutical. You could think of it like this: the market is pricing 512 as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to 512. If not, the difference in P/E might be a result of other factors. For example, if China Grand Pharmaceutical and Healthcare Holdings Limited is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with 512 are not fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.