China Weaving Materials Holdings Limited (SEHK:3778) is trading with a trailing P/E of 15.6x, which is higher than the industry average of 14.5x. While this makes 3778 appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for China Weaving Materials Holdings

Demystifying the P/E 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 3778

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

3778 Price-Earnings Ratio = CN¥0.44 ÷ CN¥0.028 = 15.6x

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 3778, 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. Since 3778’s P/E of 15.6x is higher than its industry peers (14.5x), it means that investors are paying more than they should for each dollar of 3778’s earnings. Therefore, according to this analysis, 3778 is an over-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to sell your 3778 shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 3778. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with 3778, 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 3778 to are fairly valued by the market. If this is violated, 3778’s P/E may be lower than its peers as they are actually overvalued by investors.

To help readers see pass 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.