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Hengtai Securities Co Ltd (SEHK:1476) is trading with a trailing P/E of 9.2x, which is lower than the industry average of 12.7x. While this makes 1476 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 explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Hengtai Securities
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 1476
Price-Earnings Ratio = Price per share ÷ Earnings per share
1476 Price-Earnings Ratio = CN¥2.14 ÷ CN¥0.232 = 9.2x
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 1476, 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 1476’s P/E of 9.2x is lower than its industry peers (12.7x), it means that investors are paying less than they should for each dollar of 1476’s earnings. As such, our analysis shows that 1476 represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy 1476 immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 1476. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with 1476, 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 1476 to are fairly valued by the market. If this is violated, 1476’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on 1476, the undervaluation of the stock may mean it is a good time to top up on 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 urge you to complete your research by taking a look at the following: