In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
SINOPEC Engineering (Group) Co Ltd (HKG:2386) is currently trading at a trailing P/E of 20, which is higher than the industry average of 11.3. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. Today, 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 SINOPEC Engineering (Group)
Demystifying 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 2386
Price-Earnings Ratio = Price per share ÷ Earnings per share
2386 Price-Earnings Ratio = CN¥6.34 ÷ CN¥0.317 = 20x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 2386, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. 2386’s P/E of 20 is higher than its industry peers (11.3), which implies that each dollar of 2386’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Construction companies in HK including PYI, HPC Holdings and Hanison Construction Holdings. You could think of it like this: the market is pricing 2386 as if it is a stronger company than the average of its industry group.
A few caveats
However, you should be aware that this analysis makes certain assumptions. The first is that our “similar companies” are actually similar to 2386. If not, the difference in P/E might be a result of other factors. For example, SINOPEC Engineering (Group) Co Ltd could be growing more quickly than the companies we’re comparing it with. In that case it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to 2386 may not be fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.
What this means for you:
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 2386. 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following: