GCL New Energy Holdings Limited (SEHK:451) is trading with a trailing P/E of 14.8x, which is higher than the industry average of 11.9x. While this makes 451 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for GCL New Energy Holdings

Demystifying the P/E ratio

P/E is a popular ratio used for relative valuation. 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 451

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

451 Price-Earnings Ratio = CN¥0.49 ÷ CN¥0.033 = 14.8x

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 451, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since 451’s P/E of 14.8x is higher than its industry peers (11.9x), it means that investors are paying more than they should for each dollar of 451’s earnings. Therefore, according to this analysis, 451 is an over-priced stock.

Assumptions to be aware of

Before you jump to the conclusion that 451 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 451, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 451, 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 451 to are fairly valued by the market. If this does not hold, there is a possibility that 451’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to 451. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.