Greentown Service Group Co Ltd. (SEHK:2869) trades with a trailing P/E of 38.8x, which is higher than the industry average of 20.5x. 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. View our latest analysis for Greentown Service Group

What you need to know about 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 2869

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

2869 Price-Earnings Ratio = CN¥4.75 ÷ CN¥0.123 = 38.8x

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 2869, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since 2869’s P/E of 38.8x is higher than its industry peers (20.5x), it means that investors are paying more than they should for each dollar of 2869’s earnings. As such, our analysis shows that 2869 represents an over-priced stock.

Assumptions to be aware of

However, before you rush out to sell your 2869 shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to 2869. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with 2869, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing 2869 to are fairly valued by the market. If this does not hold true, 2869’s lower P/E ratio may be because firms in our peer group are 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.