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Halcyon Agri Corporation Limited (SGX:5VJ) trades with a trailing P/E of 31.4x, which is higher than the industry average of 12x. 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. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Halcyon Agri
What you need to know about the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 5VJ
Price-Earnings Ratio = Price per share ÷ Earnings per share
5VJ Price-Earnings Ratio = $0.42 ÷ $0.014 = 31.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 5VJ, 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 5VJ’s P/E of 31.4x is higher than its industry peers (12x), it means that investors are paying more than they should for each dollar of 5VJ’s earnings. As such, our analysis shows that 5VJ represents an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that 5VJ should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to 5VJ. 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 5VJ, 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 5VJ to are fairly valued by the market. If this does not hold true, 5VJ’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on 5VJ, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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: