The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

ZMFY Automobile Glass Services Limited (HKG:8135) is trading with a trailing P/E of 5.6x, which is lower than the industry average of 10.6x. While this makes 8135 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.

See our latest analysis for ZMFY Automobile Glass Services

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 8135

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

8135 Price-Earnings Ratio = CN¥0.27 ÷ CN¥0.0479 = 5.6x

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 8135, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 8135’s P/E of 5.6 is lower than its industry peers (10.6), which implies that each dollar of 8135’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Specialty Retail companies in HK including Sunfonda Group Holdings, Beijing Digital Telecom and China Harmony New Energy Auto Holding. You can think of it like this: the market is suggesting that 8135 is a weaker business than the average comparable company.

Assumptions to watch out for

However, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to 8135, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 8135, 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 8135 to are fairly valued by the market. If this is violated, 8135’s P/E may be lower than its peers as they are actually overvalued by investors.