China Zheshang Bank Co Ltd (SEHK:2016) is trading with a trailing P/E of 6x, which is lower than the industry average of 7.1x. While this makes 2016 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 China Zheshang Bank
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 2016
Price-Earnings Ratio = Price per share ÷ Earnings per share
2016 Price-Earnings Ratio = CN¥3.7 ÷ CN¥0.614 = 6x
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 2016, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. 2016’s P/E of 6x is lower than its industry peers (7.1x), which implies that each dollar of 2016’s earnings is being undervalued by investors. As such, our analysis shows that 2016 represents an under-priced stock.
A few caveats
Before you jump to the conclusion that 2016 is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to 2016, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 2016, 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 2016 to are fairly valued by the market. If this does not hold true, 2016’s lower P/E ratio may be because firms in our peer group are 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 undervaluation could signal a good buying opportunity to increase your exposure to 2016. 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.