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MECOM Power and Construction Limited (SEHK:1183) is trading with a trailing P/E of 20.9x, which is higher than the industry average of 13.6x. While 1183 might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for MECOM Power and Construction
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 1183
Price-Earnings Ratio = Price per share ÷ Earnings per share
1183 Price-Earnings Ratio = MOP1.7 ÷ MOP0.081 = 20.9x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 1183, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 20.9x, 1183’s P/E is higher than its industry peers (13.6x). This implies that investors are overvaluing each dollar of 1183’s earnings. As such, our analysis shows that 1183 represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that 1183 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 1183. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with 1183, 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 1183 to are fairly valued by the market. If this does not hold, there is a possibility that 1183’s P/E is lower because our peer group is 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 1183. 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 urge you to complete your research by taking a look at the following: