China Everbright Water Limited (SGX:U9E) is currently trading at a trailing P/E of 16x, which is lower than the industry average of 16.3x. 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 explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for China Everbright Water
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 U9E
Price-Earnings Ratio = Price per share ÷ Earnings per share
U9E Price-Earnings Ratio = HK$2.79 ÷ HK$0.174 = 16x
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 U9E, 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 16x, U9E’s P/E is lower than its industry peers (16.3x). This implies that investors are undervaluing each dollar of U9E’s earnings. Therefore, according to this analysis, U9E is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that U9E is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to U9E, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with U9E, 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 U9E to are fairly valued by the market. If this does not hold true, U9E’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? 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 U9E 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.
Are you a potential investor? If you are considering investing in U9E, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.