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CGN Power Co Ltd. (SEHK:1816) trades with a trailing P/E of 7.8x, which is lower than the industry average of 10.1x. 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. 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 CGN Power
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for 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 1816
Price-Earnings Ratio = Price per share ÷ Earnings per share
1816 Price-Earnings Ratio = CN¥1.63 ÷ CN¥0.209 = 7.8x
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 1816, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 1816’s P/E of 7.8x is lower than its industry peers (10.1x), which implies that each dollar of 1816’s earnings is being undervalued by investors. As such, our analysis shows that 1816 represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy 1816 immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 1816, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 1816, 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 1816 to are fairly valued by the market. If this is violated, 1816’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.