I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.

Zhi Sheng Group Holdings Limited (HKG:8370) is currently trading at a trailing P/E of 8.9x, which is lower than the industry average of 14.5x. While 8370 might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.

View our latest analysis for Zhi Sheng Group Holdings

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief 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 8370

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

8370 Price-Earnings Ratio = CN¥0.21 ÷ CN¥0.0234 = 8.9x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 8370, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since 8370’s P/E of 8.9 is lower than its industry peers (14.5), it means that investors are paying less for each dollar of 8370’s earnings. This multiple is a median of profitable companies of 24 Commercial Services companies in HK including REF Holdings, Beijing Enterprises Environment Group and China Boqi Environmental (Holding). One could put it like this: the market is pricing 8370 as if it is a weaker company than the average company in its industry.

Assumptions to watch out for

However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to 8370. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with 8370, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 8370 to are fairly valued by the market. If this does not hold, there is a possibility that 8370’s P/E is lower because our peer group is overvalued by the market.