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Emperor Watch & Jewellery Limited (SEHK:887) is currently trading at a trailing P/E of 21.3x, which is higher than the industry average of 14.1x. While 887 might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Emperor Watch & Jewellery
Breaking down 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. 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 887
Price-Earnings Ratio = Price per share ÷ Earnings per share
887 Price-Earnings Ratio = HK$0.5 ÷ HK$0.023 = 21.3x
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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 887, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since 887’s P/E of 21.3x is higher than its industry peers (14.1x), it means that investors are paying more than they should for each dollar of 887’s earnings. As such, our analysis shows that 887 represents an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your 887 shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 887, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 887, 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 887 to are fairly valued by the market. If this does not hold true, 887’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
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 887. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following: