The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

Chongqing Iron & Steel Company Limited (HKG:1053) trades with a trailing P/E of 8.9x, which is lower than the industry average of 12.4x. While 1053 might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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.

See our latest analysis for Chongqing Iron & Steel

Demystifying the P/E ratio

P/E is a popular ratio used for relative valuation. 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 1053

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

1053 Price-Earnings Ratio = CN¥1.12 ÷ CN¥0.127 = 8.9x

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 1053, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since 1053’s P/E of 8.9x is lower than its industry peers (12.4x), it means that investors are paying less than they should for each dollar of 1053’s earnings. This multiple is a median of profitable companies of 24 Metals and Mining companies in HK including Mongolian Mining, Hong Kong Finance Investment Holding Group and IRC. Therefore, according to this analysis, 1053 is an under-priced stock.

A few caveats

While our conclusion might prompt you to buy 1053 immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 1053, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 1053, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing 1053 to are fairly valued by the market. If this does not hold, there is a possibility that 1053’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 1053, 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: