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.