This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
China Nonferrous Mining Corporation Limited (HKG:1258) is currently trading at a trailing P/E of 4.7x, which is lower than the industry average of 8.9x. While 1258 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
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What you need to know about the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 1258
Price-Earnings Ratio = Price per share ÷ Earnings per share
1258 Price-Earnings Ratio = $0.24 ÷ $0.0503 = 4.7x
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 1258, 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 4.7, 1258’s P/E is lower than its industry peers (8.9). This implies that investors are undervaluing each dollar of 1258’s earnings. 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 1258 is a weaker business than the average comparable company.
A few caveats
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 1258, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 1258, 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 1258 to are fairly valued by the market. If this is violated, 1258’s P/E may be lower than its peers as they are actually overvalued by investors.