In This Article:
The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
SOHO China Limited (HKG:410) is trading with a trailing P/E of 6.6, which is higher than the industry average of 5.1. Though this might seem to be a negative, 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.
Check out our latest analysis for SOHO China
Demystifying the P/E ratio
P/E is a popular ratio used for 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 410
Price-Earnings Ratio = Price per share ÷ Earnings per share
410 Price-Earnings Ratio = CN¥2.34 ÷ CN¥0.355 = 6.6x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 410, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 410’s P/E of 6.6 is higher than its industry peers (5.1), which implies that each dollar of 410’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Real Estate companies in HK including Chinney Investments, Top Spring International Holdings and Hon Kwok Land Investment Company. You could think of it like this: the market is pricing 410 as if it is a stronger company than the average of its industry group.
A few caveats
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to 410. If not, the difference in P/E might be a result of other factors. For example, if SOHO China Limited is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with 410 are not fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to 410. 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 urge you to complete your research by taking a look at the following: