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International Entertainment Corporation (SEHK:1009) is currently trading at a trailing P/E of 77x, which is higher than the industry average of 7.3x. While this makes 1009 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. 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 International Entertainment
What you need to know about 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 1009
Price-Earnings Ratio = Price per share ÷ Earnings per share
1009 Price-Earnings Ratio = HK$1.77 ÷ HK$0.023 = 77x
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 1009, 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 1009’s P/E of 77x is higher than its industry peers (7.3x), it means that investors are paying more than they should for each dollar of 1009’s earnings. Therefore, according to this analysis, 1009 is an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your 1009 shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to 1009, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 1009, 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 1009 to are fairly valued by the market. If this does not hold true, 1009’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on 1009, 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 urge you to complete your research by taking a look at the following: