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Somerley Capital Holdings Limited (SEHK:8439) trades with a trailing P/E of 39.8x, which is higher than the industry average of 12.9x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Somerley Capital Holdings
Breaking down 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 8439
Price-Earnings Ratio = Price per share ÷ Earnings per share
8439 Price-Earnings Ratio = HK$1.79 ÷ HK$0.045 = 39.8x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 8439, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. At 39.8x, 8439’s P/E is higher than its industry peers (12.9x). This implies that investors are overvaluing each dollar of 8439’s earnings. As such, our analysis shows that 8439 represents an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your 8439 shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 8439. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with 8439, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 8439 to are fairly valued by the market. If this is violated, 8439’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
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 8439. 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. 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 highly recommend you to complete your research by taking a look at the following: