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 learn about the link between company’s fundamentals and stock market performance.

China Water Affairs Group Limited (HKG:855) trades with a trailing P/E of 12.1, which is higher than the industry average of 9. 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 explain what the P/E ratio is as well as what you should look out for when using it.

Check out our latest analysis for China Water Affairs Group

Demystifying the P/E 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 855

Price-Earnings Ratio = Price per share ÷ Earnings per share

855 Price-Earnings Ratio = HK$8.77 ÷ HK$0.726 = 12.1x

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 855, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 855’s P/E of 12.1 is higher than its industry peers (9), which implies that each dollar of 855’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 9 Water Utilities companies in HK including Kangda International Environmental, Yunnan Water Investment and Kunming Dianchi Water Treatment. You could think of it like this: the market is pricing 855 as if it is a stronger company than the average of its industry group.

Assumptions to be aware of

However, it is important to note that our examination of the stock is based on certain assumptions. The first is that our “similar companies” are actually similar to 855. If not, the difference in P/E might be a result of other factors. For example, if China Water Affairs Group Limited is growing faster than its peers, then it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to 855 may not be 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.

What this means for you:

Since you may have already conducted your due diligence on 855, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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 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 855’s future growth? Take a look at our free research report of analyst consensus for 855’s outlook.

2. Past Track Record: Has 855 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 855’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.