Sinotrans Shipping Limited (SEHK:368) is trading with a trailing P/E of 36.6x, which is higher than the industry average of 14.7x. 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. In this article, 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 Sinotrans Shipping

Breaking down the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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 368

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

368 Price-Earnings Ratio = $0.3 ÷ $0.008 = 36.6x

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 368, 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. 368’s P/E of 36.6x is higher than its industry peers (14.7x), which implies that each dollar of 368’s earnings is being overvalued by investors. As such, our analysis shows that 368 represents an over-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to sell your 368 shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 368. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with 368, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing 368 to are fairly valued by the market. If this is violated, 368’s P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

Since you may have already conducted your due diligence on 368, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. 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: