Fosun International Limited (SEHK:656) is currently trading at a trailing P/E of 8.8x, which is higher than the industry average of 7.7x. While 656 might seem like a stock to avoid or sell if you own it, 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. See our latest analysis for Fosun International

Demystifying the P/E 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 656

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

656 Price-Earnings Ratio = CN¥13.54 ÷ CN¥1.535 = 8.8x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 656, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since 656’s P/E of 8.8x is higher than its industry peers (7.7x), it means that investors are paying more than they should for each dollar of 656’s earnings. As such, our analysis shows that 656 represents an over-priced stock.

A few caveats

However, before you rush out to sell your 656 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 656. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with 656, 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 656 to are fairly valued by the market. If this does not hold true, 656’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to 656. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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: