In This Article:
The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Dongfeng Motor Group Company Limited (HKG:489) trades with a trailing P/E of 4.1x, which is lower than the industry average of 9.1x. While this makes 489 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Check out our latest analysis for Dongfeng Motor Group
What you need to know about the P/E ratio
P/E is a popular ratio used for relative valuation. 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 489
Price-Earnings Ratio = Price per share ÷ Earnings per share
489 Price-Earnings Ratio = CN¥7.15 ÷ CN¥1.753 = 4.1x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 489, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since 489’s P/E of 4.1 is lower than its industry peers (9.1), it means that investors are paying less for each dollar of 489’s earnings. This multiple is a median of profitable companies of 8 Auto companies in HK including Great Wall Motor, Guangzhou Automobile Group and Geely Automobile Holdings. You can think of it like this: the market is suggesting that 489 is a weaker business than the average comparable company.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 489. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with 489, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing 489 to are fairly valued by the market. If this is violated, 489’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on 489, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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: