I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Beijing Capital Land Ltd (HKG:2868) trades with a trailing P/E of 3.8x, which is lower than the industry average of 5.6x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, 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 Beijing Capital Land
Breaking down the Price-Earnings 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 2868
Price-Earnings Ratio = Price per share ÷ Earnings per share
2868 Price-Earnings Ratio = CN¥2.45 ÷ CN¥0.641 = 3.8x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 2868, 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. 2868’s P/E of 3.8 is lower than its industry peers (5.6), which implies that each dollar of 2868’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 25 Real Estate companies in HK including Top Spring International Holdings, Chinney Investments and Hon Kwok Land Investment Company. You can think of it like this: the market is suggesting that 2868 is a weaker business than the average comparable company.
A few caveats
However, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 2868, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 2868, 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 2868 to are fairly valued by the market. If this is violated, 2868’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 2868 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: