In This Article:
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.
Sichuan Expressway Company Limited (HKG:107) is trading with a trailing P/E of 7x, which is lower than the industry average of 8.2x. While 107 might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 Sichuan Expressway
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for 107
Price-Earnings Ratio = Price per share ÷ Earnings per share
107 Price-Earnings Ratio = CN¥2.06 ÷ CN¥0.294 = 7x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 107, 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. At 7, 107’s P/E is lower than its industry peers (8.2). This implies that investors are undervaluing each dollar of 107’s earnings. This multiple is a median of profitable companies of 22 Infrastructure companies in HK including China Dredging Environment Protection Holdings, Regal International Airport Group and Qilu Expressway. One could put it like this: the market is pricing 107 as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to 107, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 107, 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 107 to are fairly valued by the market. If this is violated, 107’s P/E may be lower than its peers as they are actually overvalued by investors.