I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Sany Heavy Equipment International Holdings Company Limited (HKG:631) is trading with a trailing P/E of 15.6, which is higher than the industry average of 10.4. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. 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 Sany Heavy Equipment International Holdings
Demystifying 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 631
Price-Earnings Ratio = Price per share ÷ Earnings per share
631 Price-Earnings Ratio = CN¥2.34 ÷ CN¥0.150 = 15.6x
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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 631, 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. 631’s P/E of 15.6 is higher than its industry peers (10.4), which implies that each dollar of 631’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Machinery companies in HK including CW Group Holdings, Wuxi Sunlit Science and Technology and Asia Tele-Net and Technology. You could also say that the market is suggesting that 631 is a stronger business than the average comparable company.
Assumptions to be aware of
However, you should be aware that this analysis makes certain assumptions. The first is that our “similar companies” are actually similar to 631. If not, the difference in P/E might be a result of other factors. For example, Sany Heavy Equipment International Holdings Company Limited could be growing more quickly than the companies we’re comparing it with. In that case it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with 631 are not fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.