This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.

Giordano International Limited (HKG:709) is currently trading at a trailing P/E of 12.3, which is higher than the industry average of 11.1. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.

See our latest analysis for Giordano International

Demystifying 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 709

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

709 Price-Earnings Ratio = HK$3.98 ÷ HK$0.324 = 12.3x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 709, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since 709’s P/E of 12.3 is higher than its industry peers (11.1), it means that investors are paying more for each dollar of 709’s earnings. This multiple is a median of profitable companies of 24 Specialty Retail companies in HK including Sunfonda Group Holdings, Beijing Digital Telecom and China Harmony New Energy Auto Holding. You could also say that the market is suggesting that 709 is a stronger business than the average comparable company.

A few caveats

However, you should be aware that this analysis makes certain assumptions. Firstly, that our peer group contains companies that are similar to 709. If this isn’t the case, the difference in P/E could be due to other factors. For example, if Giordano International Limited is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with 709 are not fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.

What this means for you:

Since you may have already conducted your due diligence on 709, the overvaluation of the stock may mean it is a good time to reduce 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 highly recommend you to complete your research by taking a look at the following: