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.
Amber Energy Limited (HKG:90) is trading with a trailing P/E of 7.6x, which is lower than the industry average of 10.6x. While this makes 90 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.
See our latest analysis for Amber Energy
Breaking down 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 90
Price-Earnings Ratio = Price per share ÷ Earnings per share
90 Price-Earnings Ratio = CN¥0.58 ÷ CN¥0.0769 = 7.6x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 90, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 7.6, 90’s P/E is lower than its industry peers (10.6). This implies that investors are undervaluing each dollar of 90’s earnings. This multiple is a median of profitable companies of 22 Renewable Energy companies in HK including Beijing Jingneng Clean Energy, China Datang Renewable Power and Huadian Fuxin Energy. You can think of it like this: the market is suggesting that 90 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 90, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 90, 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 90 to are fairly valued by the market. If this does not hold true, 90’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 90 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: