Quanzhou Huixin Micro-Credit Co Ltd. (SEHK:1577) trades with a trailing P/E of 9.5x, which is higher than the industry average of 8.3x. 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 Quanzhou Huixin Micro-Credit

What you need to know about the P/E ratio

P/E is a popular ratio used for relative valuation. 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 1577

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

1577 Price-Earnings Ratio = CN¥1.28 ÷ CN¥0.134 = 9.5x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 1577, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since 1577’s P/E of 9.5x is higher than its industry peers (8.3x), it means that investors are paying more than they should for each dollar of 1577’s earnings. As such, our analysis shows that 1577 represents an over-priced stock.

Assumptions to watch out for

However, before you rush out to sell your 1577 shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to 1577. 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 1577, 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 1577 to are fairly valued by the market. If this does not hold, there is a possibility that 1577’s P/E is lower because our peer group is overvalued by the market.

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.