In This Article:
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.
NWS Holdings Limited (HKG:659) is trading with a trailing P/E of 9.6, which is higher than the industry average of 7.7. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Check out our latest analysis for NWS Holdings
Demystifying the P/E ratio
P/E is a popular ratio used for relative valuation. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for 659
Price-Earnings Ratio = Price per share ÷ Earnings per share
659 Price-Earnings Ratio = HK$14.9 ÷ HK$1.56 = 9.6x
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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 659, 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. 659’s P/E of 9.6 is higher than its industry peers (7.7), which implies that each dollar of 659’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 10 Industrials companies in HK including Chevalier International Holdings, Shanghai Industrial Holdings and Chongqing Machinery & Electric. You could also say that the market is suggesting that 659 is a stronger business than the average comparable company.
Assumptions to be aware of
However, it is important to note that our examination of the stock is based on certain assumptions. The first is that our “similar companies” are actually similar to 659. If not, the difference in P/E might be a result of other factors. For example, NWS Holdings 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. We should also be aware that the stocks we are comparing to 659 may not be 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:
Since you may have already conducted your due diligence on 659, 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. 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: