In This Article:
I am writing today to help inform people who are new to 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.
Shineroad International Holdings Limited (HKG:1587) is trading with a trailing P/E of 11.1x, which is lower than the industry average of 14.2x. While this makes 1587 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.
View our latest analysis for Shineroad International Holdings
Demystifying 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 1587
Price-Earnings Ratio = Price per share ÷ Earnings per share
1587 Price-Earnings Ratio = CN¥0.46 ÷ CN¥0.0413 = 11.1x
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 1587, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 1587’s P/E of 11.1 is lower than its industry peers (14.2), which implies that each dollar of 1587’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 18 Consumer Retailing companies in HK including Hong Kong Food Investment Holdings, China Fortune Investments (Holding) and C.P. Lotus. One could put it like this: the market is pricing 1587 as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to 1587, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 1587, 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 1587 to are fairly valued by the market. If this does not hold true, 1587’s lower P/E ratio may be because firms in our peer group are overvalued by the market.