I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.

Harbin Bank Co Ltd (HKG:6138) trades with a trailing P/E of 3.2x, which is lower than the industry average of 6.2x. While this makes 6138 appear like a great stock to buy, 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.

See our latest analysis for Harbin Bank

Demystifying 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 6138

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

6138 Price-Earnings Ratio = CN¥1.5 ÷ CN¥0.472 = 3.2x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 6138, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since 6138’s P/E of 3.2 is lower than its industry peers (6.2), it means that investors are paying less for each dollar of 6138’s earnings. This multiple is a median of profitable companies of 24 Banks companies in HK including Shengjing Bank, Bank of Chongqing and Chongqing Rural Commercial Bank. One could put it like this: the market is pricing 6138 as if it is a weaker company than the average company in its industry.

A few caveats

However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to 6138. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with 6138, 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 6138 to are fairly valued by the market. If this is violated, 6138’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 add more of 6138 to your portfolio. 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:

1. Future Outlook: What are well-informed industry analysts predicting for 6138’s future growth? Take a look at our free research report of analyst consensus for 6138’s outlook.

2. Past Track Record: Has 6138 been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of 6138’s historicals for more clarity.

3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

To help readers see past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.