Shanghai Prime Machinery Company Limited (SEHK:2345) is trading with a trailing P/E of 6.8x, which is lower than the industry average of 15.3x. While this makes 2345 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Shanghai Prime Machinery

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 2345

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

2345 Price-Earnings Ratio = CN¥1.23 ÷ CN¥0.18 = 6.8x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 2345, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since 2345’s P/E of 6.8x is lower than its industry peers (15.3x), it means that investors are paying less than they should for each dollar of 2345’s earnings. Therefore, according to this analysis, 2345 is an under-priced stock.

Assumptions to watch out for

However, before you rush out to buy 2345, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to 2345, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 2345, 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 2345 to are fairly valued by the market. If this does not hold, there is a possibility that 2345’s P/E is lower because our peer group is overvalued by the market.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.