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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
China Merchants Land Limited (HKG:978) is trading with a trailing P/E of 2.9x, which is lower than the industry average of 6x. 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. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
See our latest analysis for China Merchants Land
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 978
Price-Earnings Ratio = Price per share ÷ Earnings per share
978 Price-Earnings Ratio = CN¥1.04 ÷ CN¥0.362 = 2.9x
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 978, 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 2.9, 978’s P/E is lower than its industry peers (6). This implies that investors are undervaluing each dollar of 978’s earnings. This multiple is a median of profitable companies of 25 Real Estate companies in HK including Fullsun International Holdings Group, Top Spring International Holdings and Chinney Investments. You can think of it like this: the market is suggesting that 978 is a weaker business than the average comparable company.
A few caveats
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 978. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with 978, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 978 to are fairly valued by the market. If this does not hold, there is a possibility that 978’s P/E is lower because our peer group is overvalued by the market.