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This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Nam Lee Pressed Metal Industries Limited (SGX:G0I) is currently trading at a trailing P/E of 8.7x, which is lower than the industry average of 19.5x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
See our latest analysis for Nam Lee Pressed Metal Industries
Breaking down the Price-Earnings 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 G0I
Price-Earnings Ratio = Price per share ÷ Earnings per share
G0I Price-Earnings Ratio = SGD0.38 ÷ SGD0.0429 = 8.7x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 G0I, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. G0I’s P/E of 8.7 is lower than its industry peers (19.5), which implies that each dollar of G0I’s earnings is being undervalued by investors. Since the Building sector in SG is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as Compact Metal Industries, Design Studio Group and . One could put it like this: the market is pricing G0I as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
However, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to G0I, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with G0I, 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 G0I to are fairly valued by the market. If this does not hold, there is a possibility that G0I’s P/E is lower because our peer group is overvalued by the market.