Asia Commercial Holdings Limited (SEHK:104) is trading with a trailing P/E of 11.1x, which is lower than the industry average of 16.2x. While this makes 104 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Asia Commercial Holdings
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 104
Price-Earnings Ratio = Price per share ÷ Earnings per share
104 Price-Earnings Ratio = HK$0.23 ÷ HK$0.021 = 11.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 104, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. At 11.1x, 104’s P/E is lower than its industry peers (16.2x). This implies that investors are undervaluing each dollar of 104’s earnings. As such, our analysis shows that 104 represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy 104 immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 104, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 104, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 104 to are fairly valued by the market. If this is violated, 104’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? 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 104. 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.
Are you a potential investor? If 104 has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.