In This Article:
Greentown Service Group Co Ltd. (SEHK:2869) is trading with a trailing P/E of 47.5x, which is higher than the industry average of 22.8x. While this makes 2869 appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Greentown Service Group
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 2869
Price-Earnings Ratio = Price per share ÷ Earnings per share
2869 Price-Earnings Ratio = CN¥6.62 ÷ CN¥0.139 = 47.5x
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 2869, 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 2869’s P/E of 47.5x is higher than its industry peers (22.8x), it means that investors are paying more than they should for each dollar of 2869’s earnings. As such, our analysis shows that 2869 represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that 2869 should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to 2869. 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 2869, 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 2869 to are fairly valued by the market. If this does not hold true, 2869’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 2869. 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 highly recommend you to complete your research by taking a look at the following: