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.

Chiho Environmental Group Limited (HKG:976) is trading with a trailing P/E of 8.5, which is close to the industry average of 8.6. While 976 might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.

See our latest analysis for Chiho Environmental Group

What you need to know about the P/E 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 976

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

976 Price-Earnings Ratio = HK$2.98 ÷ HK$0.349 = 8.5x

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 976, 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. Chiho Environmental Group Limited (HKG:976) trades on a trailing P/E of 8.5. This isn’t too far from the industry average (which is 8.6). This multiple is a median of profitable companies of 24 Metals and Mining companies in HK including IRC, Hong Kong Finance Investment Holding Group and E-Commodities Holdings. You can think of it like this: the market is suggesting that 976 has similar prospects to its peers in the same industry.

Assumptions to be aware of

Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to 976, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 976, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 976 to are fairly valued by the market. If this does not hold, there is a possibility that 976’s P/E is lower because our peer group is overvalued by the market.