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New World Development Company Limited (SEHK:17) is trading with a trailing P/E of 7.7x, which is higher than the industry average of 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 explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for New World Development
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 17
Price-Earnings Ratio = Price per share ÷ Earnings per share
17 Price-Earnings Ratio = HK$11.54 ÷ HK$1.495 = 7.7x
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 17, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since 17’s P/E of 7.7x is higher than its industry peers (7x), it means that investors are paying more than they should for each dollar of 17’s earnings. As such, our analysis shows that 17 represents an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your 17 shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to 17. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with 17, 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 17 to are fairly valued by the market. If this does not hold, there is a possibility that 17’s P/E is lower because our peer group is expensive by the market.
What this means for you:
Since you may have already conducted your due diligence on 17, 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: