This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.

Top Education Group Ltd (HKG:1752) trades with a trailing P/E of 79.7, which is higher than the industry average of 23.7. 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 explain what the P/E ratio is as well as what you should look out for when using it.

Check out our latest analysis for Top Education Group

Breaking down the Price-Earnings 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 1752

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

1752 Price-Earnings Ratio = A$0.063 ÷ A$0.000785 = 79.7x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 1752, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since 1752’s P/E of 79.7 is higher than its industry peers (23.7), it means that investors are paying more for each dollar of 1752’s earnings. This multiple is a median of profitable companies of 25 Consumer Services companies in HK including Heng Sheng Holdings, China Chunlai Education Group and Water Oasis Group. You could also say that the market is suggesting that 1752 is a stronger business than the average comparable company.

A few caveats

Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to 1752. If not, the difference in P/E might be a result of other factors. For example, Top Education Group 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. Of course, it is possible that the stocks we are comparing with 1752 are not 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.