Fire Rock Holdings Limited (SEHK:8345) is trading with a trailing P/E of 19.4x, which is lower than the industry average of 25.1x. 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 explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Fire Rock Holdings

Demystifying 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 8345

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

8345 Price-Earnings Ratio = CN¥4.7 ÷ CN¥0.242 = 19.4x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 8345, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since 8345’s P/E of 19.4x is lower than its industry peers (25.1x), it means that investors are paying less than they should for each dollar of 8345’s earnings. As such, our analysis shows that 8345 represents an under-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to buy 8345 immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 8345, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 8345, 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 8345 to are fairly valued by the market. If this does not hold, there is a possibility that 8345’s P/E is lower because our peer group is overvalued by the market.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.