This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.

New Toyo International Holdings Ltd (SGX:N08) is currently trading at a trailing P/E of 23.2x, which is higher than the industry average of 17.6x. While this makes N08 appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.

Check out our latest analysis for New Toyo International 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 N08

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

N08 Price-Earnings Ratio = SGD0.23 ÷ SGD0.00992 = 23.2x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to N08, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 23.2x, N08’s P/E is higher than its industry peers (14.6x). This implies that investors are overvaluing each dollar of N08’s earnings. Since the Forestry sector in SG is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as LHT Holdings, Samko Timber and Avarga. As such, our analysis shows that N08 represents an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your N08 shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to N08, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with N08, 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 N08 to are fairly valued by the market. If this does not hold, there is a possibility that N08’s P/E is lower because our peer group is overvalued by the market.