Dongguang Chemical Limited (SEHK:1702) is currently trading at a trailing P/E of 52.5x, which is higher than the industry average of 11.1x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, 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 Dongguang Chemical

Breaking down the Price-Earnings ratio

The P/E ratio is one of many ratios used in 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 1702

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

1702 Price-Earnings Ratio = CN¥3.55 ÷ CN¥0.068 = 52.5x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 1702, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. At 52.5x, 1702’s P/E is higher than its industry peers (11.1x). This implies that investors are overvaluing each dollar of 1702’s earnings. As such, our analysis shows that 1702 represents an over-priced stock.

A few caveats

However, before you rush out to sell your 1702 shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to 1702. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with 1702, 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 1702 to are fairly valued by the market. If this does not hold, there is a possibility that 1702’s P/E is lower because our peer group is overvalued by the market.

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.