This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Yongsheng Advanced Materials Company Limited (HKG:3608) is currently trading at a trailing P/E of 9.8x, which is lower than the industry average of 11.4x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
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What you need to know about 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. 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 3608
Price-Earnings Ratio = Price per share ÷ Earnings per share
3608 Price-Earnings Ratio = CN¥2.22 ÷ CN¥0.226 = 9.8x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 3608, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. 3608’s P/E of 9.8 is lower than its industry peers (11.4), which implies that each dollar of 3608’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 25 Luxury companies in HK including Hingtex Holdings, Hosa International and Victory City International Holdings. You can think of it like this: the market is suggesting that 3608 is a weaker business than the average comparable company.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to 3608, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 3608, 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 3608 to are fairly valued by the market. If this is violated, 3608’s P/E may be lower than its peers as they are actually overvalued by investors.