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.

China Resources Cement Holdings Limited (HKG:1313) is trading with a trailing P/E of 9.1, which is higher than the industry average of 8.3. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.

Check out our latest analysis for China Resources Cement Holdings

Breaking down the Price-Earnings 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 1313

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

1313 Price-Earnings Ratio = HK$8.32 ÷ HK$0.918 = 9.1x

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 1313, 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. 1313’s P/E of 9.1 is higher than its industry peers (8.3), which implies that each dollar of 1313’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 9 Basic Materials companies in HK including China Yu Tian Holdings, China National Building Material and West China Cement. You could also say that the market is suggesting that 1313 is a stronger business than the average comparable company.

Assumptions to be aware of

Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to 1313. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where China Resources Cement Holdings Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. We should also be aware that the stocks we are comparing to 1313 may not be fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.