The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about the link between company’s fundamentals and stock market performance.
China Wood Optimization (Holding) Limited (HKG:1885) is currently trading at a trailing P/E of 35.8, which is higher than the industry average of 8.7. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 Wood Optimization (Holding)
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in 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 1885
Price-Earnings Ratio = Price per share ÷ Earnings per share
1885 Price-Earnings Ratio = CN¥1.84 ÷ CN¥0.0515 = 35.8x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 1885, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since 1885’s P/E of 35.8 is higher than its industry peers (8.7), it means that investors are paying more for each dollar of 1885’s earnings. This multiple is a median of profitable companies of 5 Forestry companies in HK including Nine Dragons Paper (Holdings), Hong Wei (Asia) Holdings and Lee and Man Paper Manufacturing. You could think of it like this: the market is pricing 1885 as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
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 1885. If this isn’t the case, the difference in P/E could be due to other factors. Take, for example, the scenario where China Wood Optimization (Holding) 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. Of course, it is possible that the stocks we are comparing with 1885 are not 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.