This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.

China Foods Limited (HKG:506) is currently trading at a trailing P/E of 21.8, which is higher than the industry average of 14.3. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. Today, 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 China Foods

Demystifying the P/E ratio

P/E is a popular ratio used for relative valuation. 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 506

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

506 Price-Earnings Ratio = HK$3.9 ÷ HK$0.179 = 21.8x

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 506, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 506’s P/E of 21.8 is higher than its industry peers (14.3), which implies that each dollar of 506’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Food companies in HK including China Haisheng Juice Holdings, Chia Tai Enterprises International and China Starch Holdings. You could think of it like this: the market is pricing 506 as if it is a stronger company than the average of its industry group.

Assumptions to be aware of

However, it is important to note that our examination of the stock is based on certain assumptions. Firstly, that our peer group contains companies that are similar to 506. If this isn’t the case, the difference in P/E could be due to other factors. For example, China Foods Limited could be growing more quickly than the companies we’re comparing it with. In that case it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with 506 are not fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.

What this means for you:

If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in 506. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 urge you to complete your research by taking a look at the following: