Sunny Optical Technology (Group) Company Limited (SEHK:2382) trades with a trailing P/E of 48.8x, which is higher than the industry average of 13x. While 2382 might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, 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 Sunny Optical Technology (Group)

Breaking down the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for 2382

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

2382 Price-Earnings Ratio = CN¥88.51 ÷ CN¥1.816 = 48.8x

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 2382, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. 2382’s P/E of 48.8x is higher than its industry peers (13x), which implies that each dollar of 2382’s earnings is being overvalued by investors. Therefore, according to this analysis, 2382 is an over-priced stock.

Assumptions to be aware of

However, before you rush out to sell your 2382 shares, 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 2382, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 2382, 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 2382 to are fairly valued by the market. If this does not hold, there is a possibility that 2382’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? 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 2382. 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.