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Japfa Ltd (SGX:UD2) trades with a trailing P/E of 47.1x, which is higher than the industry average of 14.4x. While this makes UD2 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Japfa
What you need to know about the P/E ratio
P/E is a popular ratio used for relative valuation. 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 UD2
Price-Earnings Ratio = Price per share ÷ Earnings per share
UD2 Price-Earnings Ratio = $0.42 ÷ $0.009 = 47.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to UD2, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since UD2’s P/E of 47.1x is higher than its industry peers (14.4x), it means that investors are paying more than they should for each dollar of UD2’s earnings. Therefore, according to this analysis, UD2 is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that UD2 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 UD2. 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 UD2, 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 UD2 to are fairly valued by the market. If this is violated, UD2’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in UD2. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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: