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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about the link between company’s fundamentals and stock market performance.
SH Group (Holdings) Limited (HKG:1637) is trading with a trailing P/E of 5.7x, which is lower than the industry average of 11.1x. While this makes 1637 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 SH Group (Holdings)
What you need to know about the P/E ratio
P/E is a popular ratio used for relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for 1637
Price-Earnings Ratio = Price per share ÷ Earnings per share
1637 Price-Earnings Ratio = HK$0.51 ÷ HK$0.0890 = 5.7x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 1637, 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. 1637’s P/E of 5.7 is lower than its industry peers (11.1), which implies that each dollar of 1637’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 25 Construction companies in HK including PYI, HPC Holdings and Hanison Construction Holdings. One could put it like this: the market is pricing 1637 as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to 1637, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 1637, 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 1637 to are fairly valued by the market. If this is violated, 1637’s P/E may be lower than its peers as they are actually overvalued by investors.