China First Capital Group Limited (SEHK:1269) is currently trading at a trailing P/E of 85.6x, which is higher than the industry average of 14.6x. 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 explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for China First Capital Group

What you need to know about the P/E ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 1269

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

1269 Price-Earnings Ratio = CN¥2.6 ÷ CN¥0.03 = 85.6x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 1269, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 85.6x, 1269’s P/E is higher than its industry peers (14.6x). This implies that investors are overvaluing each dollar of 1269’s earnings. Therefore, according to this analysis, 1269 is an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your 1269 shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 1269. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with 1269, 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 1269 to are fairly valued by the market. If this does not hold true, 1269’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.