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This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
DCB Holdings Limited (HKG:8040) is trading with a trailing P/E of 10x, which is lower than the industry average of 12.3x. While 8040 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
View our latest analysis for DCB Holdings
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 8040
Price-Earnings Ratio = Price per share ÷ Earnings per share
8040 Price-Earnings Ratio = HK$0.54 ÷ HK$0.0539 = 10x
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 8040, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 10, 8040’s P/E is lower than its industry peers (12.3). This implies that investors are undervaluing each dollar of 8040’s earnings. This multiple is a median of profitable companies of 25 Construction companies in HK including PYI, HPC Holdings and Build King Holdings. You can think of it like this: the market is suggesting that 8040 is a weaker business than the average comparable company.
Assumptions to watch out for
However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to 8040. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with 8040, 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 8040 to are fairly valued by the market. If this is violated, 8040’s P/E may be lower than its peers as they are actually overvalued by investors.