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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.
Tesson Holdings Limited (HKG:1201) is trading with a trailing P/E of 3.4x, which is lower than the industry average of 9.6x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. 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 Tesson Holdings
What you need to know about 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 1201
Price-Earnings Ratio = Price per share ÷ Earnings per share
1201 Price-Earnings Ratio = HK$0.62 ÷ HK$0.181 = 3.4x
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 1201, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since 1201’s P/E of 3.4 is lower than its industry peers (9.6), it means that investors are paying less for each dollar of 1201’s earnings. This multiple is a median of profitable companies of 18 Packaging companies in HK including Hung Hing Printing Group, China Sunshine Paper Holdings and Come Sure Group (Holdings). You can think of it like this: the market is suggesting that 1201 is a weaker business than the average comparable company.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to 1201, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 1201, 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 1201 to are fairly valued by the market. If this does not hold, there is a possibility that 1201’s P/E is lower because our peer group is overvalued by the market.