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China Huarong Asset Management Co Ltd. (SEHK:2799) is trading with a trailing P/E of 3.8x, which is lower than the industry average of 14.1x. While this makes 2799 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for China Huarong Asset Management
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 2799
Price-Earnings Ratio = Price per share ÷ Earnings per share
2799 Price-Earnings Ratio = CN¥2.12 ÷ CN¥0.563 = 3.8x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 2799, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. 2799’s P/E of 3.8x is lower than its industry peers (14.1x), which implies that each dollar of 2799’s earnings is being undervalued by investors. Therefore, according to this analysis, 2799 is an under-priced stock.
A few caveats
However, before you rush out to buy 2799, 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 2799, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 2799, 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 2799 to are fairly valued by the market. If this does not hold, there is a possibility that 2799’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on 2799, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. 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: