Hong Kong Ferry (Holdings) Company Limited (SEHK:50) trades with a trailing P/E of 11.3x, which is higher than the industry average of 6.6x. While this makes 50 appear like a stock to avoid or sell if you own it, 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. View our latest analysis for Hong Kong Ferry (Holdings)
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 50
Price-Earnings Ratio = Price per share ÷ Earnings per share
50 Price-Earnings Ratio = HK$8.95 ÷ HK$0.793 = 11.3x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 50, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 11.3x, 50’s P/E is higher than its industry peers (6.6x). This implies that investors are overvaluing each dollar of 50’s earnings. As such, our analysis shows that 50 represents an over-priced stock.
A few caveats
Before you jump to the conclusion that 50 should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to 50, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 50, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing 50 to are fairly valued by the market. If this does not hold, there is a possibility that 50’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on 50, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above.
Are you a potential investor? If you are considering investing in 50, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.