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This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Dawnrays Pharmaceutical (Holdings) Limited (HKG:2348) is trading with a trailing P/E of 8.1x, which is lower than the industry average of 14.5x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
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Demystifying the P/E 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 2348
Price-Earnings Ratio = Price per share ÷ Earnings per share
2348 Price-Earnings Ratio = CN¥1.58 ÷ CN¥0.196 = 8.1x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 2348, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 2348’s P/E of 8.1 is lower than its industry peers (14.5), which implies that each dollar of 2348’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Pharmaceuticals companies in HK including Jilin Province Huinan Changlong Bio-pharmacy, China Health Group and Extrawell Pharmaceutical Holdings. One could put it like this: the market is pricing 2348 as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to 2348, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 2348, 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 2348 to are fairly valued by the market. If this does not hold, there is a possibility that 2348’s P/E is lower because our peer group is overvalued by the market.