This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Good Resources Holdings Limited (HKG:109) is trading with a trailing P/E of 16.7, which is higher than the industry average of 8. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. 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.
Check out our latest analysis for Good Resources Holdings
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 109
Price-Earnings Ratio = Price per share ÷ Earnings per share
109 Price-Earnings Ratio = HK$0.17 ÷ HK$0.0104 = 16.7x
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 109, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 16.7, 109’s P/E is higher than its industry peers (8). This implies that investors are overvaluing each dollar of 109’s earnings. This multiple is a median of profitable companies of 16 Diversified Financial companies in HK including G-Resources Group, Byleasing Holdings and Min Xin Holdings. You could think of it like this: the market is pricing 109 as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to 109. If not, the difference in P/E might be a result of other factors. For example, if Good Resources Holdings Limited is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with 109 are not fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.
What this means for you:
Since you may have already conducted your due diligence on 109, 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 urge you to complete your research by taking a look at the following: