In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.
Microware Group Limited (HKG:1985) is trading with a trailing P/E of 10.5x, which is lower than the industry average of 13.5x. 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
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What you need to know about the P/E ratio
P/E is a popular ratio used for relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for 1985
Price-Earnings Ratio = Price per share ÷ Earnings per share
1985 Price-Earnings Ratio = HK$1.05 ÷ HK$0.100 = 10.5x
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 1985, 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. Since 1985’s P/E of 10.5 is lower than its industry peers (13.5), it means that investors are paying less for each dollar of 1985’s earnings. This multiple is a median of profitable companies of 22 IT companies in HK including Green Leader Holdings Group, CCID Consulting and EFT Solutions Holdings. You can think of it like this: the market is suggesting that 1985 is a weaker business than the average comparable company.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 1985. 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 1985, 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 1985 to are fairly valued by the market. If this does not hold true, 1985’s lower P/E ratio may be because firms in our peer group are 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 undervaluation could signal a good buying opportunity to increase your exposure to 1985. 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 highly recommend you to complete your research by taking a look at the following: