In This Article:
The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Shanghai Industrial Urban Development Group Limited (HKG:563) trades with a trailing P/E of 12.7, which is higher than the industry average of 5.6. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. Today, 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 Shanghai Industrial Urban Development Group
Breaking down the Price-Earnings 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 563
Price-Earnings Ratio = Price per share ÷ Earnings per share
563 Price-Earnings Ratio = HK$1.31 ÷ HK$0.103 = 12.7x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 563, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 563’s P/E of 12.7 is higher than its industry peers (5.6), which implies that each dollar of 563’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Real Estate companies in HK including Top Spring International Holdings, Chinney Investments and Hon Kwok Land Investment Company. You could think of it like this: the market is pricing 563 as if it is a stronger company than the average of its industry group.
A few caveats
However, it is important to note that our examination of the stock is based on certain assumptions. The first is that our “similar companies” are actually similar to 563. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where Shanghai Industrial Urban Development Group Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with 563 are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.