I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Far East Consortium International Limited (HKG:35) is trading with a trailing P/E of 5.2, which is close to the industry average of 5.2. While this makes 35 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
See our latest analysis for Far East Consortium International
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 35
Price-Earnings Ratio = Price per share ÷ Earnings per share
35 Price-Earnings Ratio = HK$3.58 ÷ HK$0.691 = 5.2x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 35, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Far East Consortium International Limited (HKG:35) is trading with a trailing P/E of 5.2, which is close to the industry average of 5.2. This multiple is a median of profitable companies of 25 Real Estate companies in HK including Chinney Investments, Top Spring International Holdings and Hon Kwok Land Investment Company. One could put it like this: the market is pricing 35 as if it is roughly average for its industry.
Assumptions to watch out for
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 35. 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 35, 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 35 to are fairly valued by the market. If this does not hold, there is a possibility that 35’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to 35. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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: