Kingold Jewelry Inc (NASDAQ:KGJI) trades with a trailing P/E of 3.3x, which is lower than the industry average of 24.7x. While this makes KGJI appear like a great stock to buy, 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. View our latest analysis for Kingold Jewelry

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief 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 KGJI

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

KGJI Price-Earnings Ratio = $1.29 ÷ $0.397 = 3.3x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to KGJI, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. KGJI’s P/E of 3.3x is lower than its industry peers (24.7x), which implies that each dollar of KGJI’s earnings is being undervalued by investors. Therefore, according to this analysis, KGJI is an under-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that KGJI 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 KGJI, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with KGJI, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing KGJI to are fairly valued by the market. If this does not hold true, KGJI’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 KGJI, the undervaluation of the stock may mean it is a good time to top up on 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: