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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.
GA Holdings Limited (HKG:8126) trades with a trailing P/E of 7.2x, which is lower than the industry average of 10.9x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
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Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 8126
Price-Earnings Ratio = Price per share ÷ Earnings per share
8126 Price-Earnings Ratio = HK$0.51 ÷ HK$0.0705 = 7.2x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 8126, 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. 8126’s P/E of 7.2 is lower than its industry peers (10.9), which implies that each dollar of 8126’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 16 Retail Distributors companies in HK including Sparkle Roll Group, Eminence Enterprise and Dah Chong Hong Holdings. You can think of it like this: the market is suggesting that 8126 is a weaker business than the average comparable company.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to 8126. 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 8126, 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 8126 to are fairly valued by the market. If this does not hold, there is a possibility that 8126’s P/E is lower because our peer group is overvalued by the market.