In This Article:
I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Jiahua Stores Holdings Limited (HKG:602) is currently trading at a trailing P/E of 9.3x, which is lower than the industry average of 14.2x. While this makes 602 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
See our latest analysis for Jiahua Stores Holdings
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 602
Price-Earnings Ratio = Price per share ÷ Earnings per share
602 Price-Earnings Ratio = CN¥0.24 ÷ CN¥0.0261 = 9.3x
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 602, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since 602’s P/E of 9.3 is lower than its industry peers (14.2), it means that investors are paying less for each dollar of 602’s earnings. This multiple is a median of profitable companies of 18 Consumer Retailing companies in HK including Hong Kong Food Investment Holdings, China Fortune Investments (Holding) and C.P. Lotus. One could put it like this: the market is pricing 602 as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 602, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 602, 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 602 to are fairly valued by the market. If this is violated, 602’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
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 602. 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. 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 urge you to complete your research by taking a look at the following: