Far East Orchard Limited (SGX:O10) is trading with a trailing P/E of 29x, which is higher than the industry average of 10.3x. 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 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 Far East Orchard
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. 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 O10
Price-Earnings Ratio = Price per share ÷ Earnings per share
O10 Price-Earnings Ratio = SGD1.48 ÷ SGD0.051 = 29x
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 O10, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. O10’s P/E of 29x is higher than its industry peers (10.3x), which implies that each dollar of O10’s earnings is being overvalued by investors. Therefore, according to this analysis, O10 is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that O10 should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to O10. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with O10, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing O10 to are fairly valued by the market. If this is violated, O10’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on O10, 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: