This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

Able Engineering Holdings Limited (HKG:1627) trades with a trailing P/E of 5.8x, which is lower than the industry average of 11.1x. While this makes 1627 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.

View our latest analysis for Able Engineering Holdings

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 1627

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

1627 Price-Earnings Ratio = HK$0.51 ÷ HK$0.0875 = 5.8x

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 1627, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 5.8, 1627’s P/E is lower than its industry peers (11.1). This implies that investors are undervaluing each dollar of 1627’s earnings. This multiple is a median of profitable companies of 25 Construction companies in HK including PYI, HPC Holdings and Huarong Investment Stock. You can think of it like this: the market is suggesting that 1627 is a weaker business than the average comparable company.

A few caveats

However, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to 1627, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 1627, 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 1627 to are fairly valued by the market. If this does not hold true, 1627’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

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 1627 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 highly recommend you to complete your research by taking a look at the following: