BaWang International (Group) Holding Limited (SEHK:1338) trades with a trailing P/E of 25.3x, which is higher than the industry average of 19.6x. 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. Today, 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 BaWang International (Group) Holding

Demystifying the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 1338

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

1338 Price-Earnings Ratio = CN¥0.19 ÷ CN¥0.008 = 25.3x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 1338, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since 1338’s P/E of 25.3x is higher than its industry peers (19.6x), it means that investors are paying more than they should for each dollar of 1338’s earnings. As such, our analysis shows that 1338 represents an over-priced stock.

Assumptions to watch out for

However, before you rush out to sell your 1338 shares, 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 1338, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 1338, 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 1338 to are fairly valued by the market. If this does not hold true, 1338’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.