This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.

7Road Holdings Limited (HKG:797) is trading with a trailing P/E of 0.6x, which is lower than the industry average of 16.5x. While this makes 797 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.

View our latest analysis for 7Road Holdings

Demystifying the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 797

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

797 Price-Earnings Ratio = CN¥1.19 ÷ CN¥1.968 = 0.6x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 797, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. 797’s P/E of 0.6 is lower than its industry peers (16.5), which implies that each dollar of 797’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Software companies in HK including Beijing Beida Jade Bird Universal Sci-Tech, Boyaa Interactive International and Founder Holdings. One could put it like this: the market is pricing 797 as if it is a weaker company than the average company in its industry.

A few caveats

However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to 797. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with 797, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing 797 to are fairly valued by the market. If this is violated, 797’s P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of 797 to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 urge you to complete your research by taking a look at the following:

1. Future Outlook: What are well-informed industry analysts predicting for 797’s future growth? Take a look at our free research report of analyst consensus for 797’s outlook.

2. Financial Health: Are 797’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.

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.