This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.

Huadian Power International Corporation Limited (HKG:1071) is currently trading at a trailing P/E of 14.9, which is higher than the industry average of 11.2. 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.

See our latest analysis for Huadian Power International

Demystifying the P/E ratio

P/E is a popular ratio used for 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 1071

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

1071 Price-Earnings Ratio = CN¥2.45 ÷ CN¥0.165 = 14.9x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 1071, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 14.9, 1071’s P/E is higher than its industry peers (11.2). This implies that investors are overvaluing each dollar of 1071’s earnings. This multiple is a median of profitable companies of 22 Renewable Energy companies in HK including Beijing Jingneng Clean Energy, Huadian Fuxin Energy and China Renewable Energy Investment. You could also say that the market is suggesting that 1071 is a stronger business than the average comparable company.

Assumptions to watch out for

However, you should be aware that this analysis makes certain assumptions. Firstly, that our peer group contains companies that are similar to 1071. If this isn’t the case, the difference in P/E could be due to other factors. For example, if Huadian Power International Corporation 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 1071 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.