The Bank of East Asia Limited (SEHK:23) trades with a trailing P/E of 18.6x, which is higher than the industry average of 6.7x. While 23 might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 Bank of East Asia

Breaking down the Price-Earnings ratio

P/E is often used for relative valuation since earnings power is a chief 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 23

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

23 Price-Earnings Ratio = HK$31.3 ÷ HK$1.687 = 18.6x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 23, 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 23’s P/E of 18.6x is higher than its industry peers (6.7x), it means that investors are paying more than they should for each dollar of 23’s earnings. Therefore, according to this analysis, 23 is an over-priced stock.

A few caveats

While our conclusion might prompt you to sell your 23 shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 23, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 23, 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 23 to are fairly valued by the market. If this does not hold true, 23’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.