Hua Hong Semiconductor Limited (SEHK:1347) is trading with a trailing P/E of 13.2x, which is lower than the industry average of 16.9x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Hua Hong Semiconductor

Breaking down 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 1347

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

1347 Price-Earnings Ratio = $1.85 ÷ $0.14 = 13.2x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 1347, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. 1347’s P/E of 13.2x is lower than its industry peers (16.9x), which implies that each dollar of 1347’s earnings is being undervalued by investors. As such, our analysis shows that 1347 represents an under-priced stock.

Assumptions to be aware of

Before you jump to the conclusion that 1347 is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to 1347, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 1347, 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 1347 to are fairly valued by the market. If this is violated, 1347’s P/E may be lower than its peers as they are actually overvalued by investors.

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.