Minth Group Limited (SEHK:425) is trading with a trailing P/E of 23.3x, which is higher than the industry average of 12.8x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, 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 Minth Group

Breaking down the P/E ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 425

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

425 Price-Earnings Ratio = CN¥40.32 ÷ CN¥1.734 = 23.3x

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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 425, 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. At 23.3x, 425’s P/E is higher than its industry peers (12.8x). This implies that investors are overvaluing each dollar of 425’s earnings. As such, our analysis shows that 425 represents an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your 425 shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 425. 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 425, 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 425 to are fairly valued by the market. If this is violated, 425’s P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

Are you a shareholder? 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 425. 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.

Are you a potential investor? If you are considering investing in 425, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Minth Group for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.