Sheung Moon Holdings Limited (SEHK:8523) is trading with a trailing P/E of 12.3x, which is higher than the industry average of 10.4x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Sheung Moon 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 8523

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

8523 Price-Earnings Ratio = HK$0.44 ÷ HK$0.035 = 12.3x

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 8523, 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. 8523’s P/E of 12.3x is higher than its industry peers (10.4x), which implies that each dollar of 8523’s earnings is being overvalued by investors. As such, our analysis shows that 8523 represents an over-priced stock.

Assumptions to watch out for

However, before you rush out to sell your 8523 shares, 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 8523, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 8523, 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 8523 to are fairly valued by the market. If this is violated, 8523’s P/E may be lower than its peers as they are actually overvalued by investors.

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.