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Yuhua Energy Holdings Limited (SEHK:2728) is trading with a trailing P/E of 31.9x, which is higher than the industry average of 10.2x. While this makes 2728 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. See our latest analysis for Yuhua Energy Holdings
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 2728
Price-Earnings Ratio = Price per share ÷ Earnings per share
2728 Price-Earnings Ratio = HK$0.66 ÷ HK$0.021 = 31.9x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 2728, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 31.9x, 2728’s P/E is higher than its industry peers (10.2x). This implies that investors are overvaluing each dollar of 2728’s earnings. Therefore, according to this analysis, 2728 is an over-priced stock.
A few caveats
Before you jump to the conclusion that 2728 should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to 2728. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with 2728, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing 2728 to are fairly valued by the market. If this is violated, 2728’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in 2728. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 highly recommend you to complete your research by taking a look at the following: