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This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Goodbaby International Holdings Limited (HKG:1086) is currently trading at a trailing P/E of 19.4, which is higher than the industry average of 13.5. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. Today, 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 Goodbaby International Holdings
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 1086
Price-Earnings Ratio = Price per share ÷ Earnings per share
1086 Price-Earnings Ratio = HK$2.43 ÷ HK$0.125 = 19.4x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 1086, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since 1086’s P/E of 19.4 is higher than its industry peers (13.5), it means that investors are paying more for each dollar of 1086’s earnings. This multiple is a median of profitable companies of 10 Leisure companies in HK including Kader Holdings, Playmates Holdings and Dream International. You could also say that the market is suggesting that 1086 is a stronger business than the average comparable company.
A few caveats
However, you should be aware that this analysis makes certain assumptions. The first is that our “similar companies” are actually similar to 1086. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where Goodbaby International Holdings Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with 1086 are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.