This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.

Da Ming International Holdings Limited (HKG:1090) is trading with a trailing P/E of 10.5, which is higher than the industry average of 8.8. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.

See our latest analysis for Da Ming International Holdings

Breaking down the Price-Earnings ratio

A common ratio used for relative valuation is the P/E ratio. 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 1090

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

1090 Price-Earnings Ratio = CN¥2.09 ÷ CN¥0.198 = 10.5x

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 1090, 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 1090’s P/E of 10.5 is higher than its industry peers (8.8), it means that investors are paying more for each dollar of 1090’s earnings. This multiple is a median of profitable companies of 24 Metals and Mining companies in HK including IRC, Hong Kong Finance Investment Holding Group and E-Commodities Holdings. You could think of it like this: the market is pricing 1090 as if it is a stronger company than the average of its industry group.

Assumptions to watch out for

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 1090. If not, the difference in P/E might be a result of other factors. For example, if Da Ming International Holdings Limited is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with 1090 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:

You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to 1090. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 highly recommend you to complete your research by taking a look at the following:

1. Future Outlook: What are well-informed industry analysts predicting for 1090’s future growth? Take a look at our free research report of analyst consensus for 1090’s outlook.

2. Past Track Record: Has 1090 been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of 1090’s historicals for more clarity.

3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

To help readers see past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.