China Shenhua Energy Company Limited (SEHK:1088) is currently trading at a trailing P/E of 8.7x, which is lower than the industry average of 11.3x. While 1088 might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 China Shenhua Energy

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 1088

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

1088 Price-Earnings Ratio = CN¥19.68 ÷ CN¥2.255 = 8.7x

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 1088, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 8.7x, 1088’s P/E is lower than its industry peers (11.3x). This implies that investors are undervaluing each dollar of 1088’s earnings. Therefore, according to this analysis, 1088 is an under-priced stock.

A few caveats

However, before you rush out to buy 1088, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to 1088, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 1088, 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 1088 to are fairly valued by the market. If this does not hold, there is a possibility that 1088’s P/E is lower because our peer group is overvalued by the market.

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.