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Zhengye International Holdings Company Limited (SEHK:3363) is trading with a trailing P/E of 4.2x, which is lower than the industry average of 11.2x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Zhengye International Holdings
Demystifying 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 3363
Price-Earnings Ratio = Price per share ÷ Earnings per share
3363 Price-Earnings Ratio = CN¥1.52 ÷ CN¥0.365 = 4.2x
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 3363, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since 3363’s P/E of 4.2x is lower than its industry peers (11.2x), it means that investors are paying less than they should for each dollar of 3363’s earnings. As such, our analysis shows that 3363 represents an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy 3363 immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 3363, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 3363, 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 3363 to are fairly valued by the market. If this does not hold true, 3363’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.