APAC Realty Limited (SGX:CLN) trades with a trailing P/E of 12.5x, which is higher than the industry average of 10.6x. While this makes CLN appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, 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 APAC Realty

Breaking down the Price-Earnings ratio

The P/E ratio is one of many ratios used in relative valuation. 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 CLN

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

CLN Price-Earnings Ratio = SGD0.92 ÷ SGD0.074 = 12.5x

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 CLN, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. CLN’s P/E of 12.5x is higher than its industry peers (10.6x), which implies that each dollar of CLN’s earnings is being overvalued by investors. Therefore, according to this analysis, CLN is an over-priced stock.

A few caveats

Before you jump to the conclusion that CLN should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to CLN, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with CLN, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing CLN to are fairly valued by the market. If this does not hold, there is a possibility that CLN’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in CLN. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.

Are you a potential investor? If you are considering investing in CLN, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.