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.

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 978. 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 highly recommend you to complete your research by taking a look at the following:

1. Future Outlook: What are well-informed industry analysts predicting for 978’s future growth? Take a look at our free research report of analyst consensus for 978’s outlook.

2. Past Track Record: Has 978 been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of 978’s historicals for more clarity.

3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

To help readers see past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.