Perfectech International Holdings Limited (SEHK:765) trades with a trailing P/E of 25.4x, which is higher than the industry average of 18.6x. While 765 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. 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. Check out our latest analysis for Perfectech International Holdings

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief 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 765

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

765 Price-Earnings Ratio = HK$1.47 ÷ HK$0.058 = 25.4x

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 765, 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. At 25.4x, 765’s P/E is higher than its industry peers (18.6x). This implies that investors are overvaluing each dollar of 765’s earnings. Therefore, according to this analysis, 765 is an over-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to sell your 765 shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 765, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 765, 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 765 to are fairly valued by the market. If this does not hold, there is a possibility that 765’s P/E is lower because our peer group is overvalued by the market.

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 765. 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.