I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

Texhong Textile Group Limited (HKG:2678) trades with a trailing P/E of 8.5x, which is lower than the industry average of 11.2x. 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 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 Texhong Textile Group

Breaking down the Price-Earnings ratio

P/E is a popular ratio used for 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 2678

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

2678 Price-Earnings Ratio = CN¥10.29 ÷ CN¥1.213 = 8.5x

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 2678, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 8.5, 2678’s P/E is lower than its industry peers (11.2). This implies that investors are undervaluing each dollar of 2678’s earnings. This multiple is a median of profitable companies of 25 Luxury companies in HK including Victory City International Holdings, Hosa International and Continental Holdings. You can think of it like this: the market is suggesting that 2678 is a weaker business than the average comparable company.

Assumptions to be aware of

However, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to 2678, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 2678, 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 2678 to are fairly valued by the market. If this is violated, 2678’s P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to 2678. 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 2678’s future growth? Take a look at our free research report of analyst consensus for 2678’s outlook.

2. Past Track Record: Has 2678 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 2678’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.