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Xiabuxiabu Catering Management (China) Holdings Co Ltd. (SEHK:520) is trading with a trailing P/E of 34.9x, which is higher than the industry average of 17.8x. While 520 might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 Xiabuxiabu Catering Management (China) Holdings
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in 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 520
Price-Earnings Ratio = Price per share ÷ Earnings per share
520 Price-Earnings Ratio = CN¥13.7 ÷ CN¥0.393 = 34.9x
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 520, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 520’s P/E of 34.9x is higher than its industry peers (17.8x), which implies that each dollar of 520’s earnings is being overvalued by investors. Therefore, according to this analysis, 520 is an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your 520 shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 520, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 520, 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 520 to are fairly valued by the market. If this is violated, 520’s P/E may be lower than its peers as they are actually overvalued by investors.
To help readers see pass 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.