This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.

VSTECS Holdings Limited (HKG:856) trades with a trailing P/E of 6.9x, which is lower than the industry average of 9.6x. While 856 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.

See our latest analysis for VSTECS 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 856

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

856 Price-Earnings Ratio = HK$3.91 ÷ HK$0.568 = 6.9x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 856, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 6.9, 856’s P/E is lower than its industry peers (9.6). This implies that investors are undervaluing each dollar of 856’s earnings. This multiple is a median of profitable companies of 24 Electronic companies in HK including Wong’s International Holdings, China Soft Power Technology Holdings and AV Concept Holdings. One could put it like this: the market is pricing 856 as if it is a weaker company than the average company in its industry.

Assumptions to be aware of

However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 856. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with 856, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 856 to are fairly valued by the market. If this does not hold, there is a possibility that 856’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to 856. 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 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 856’s future growth? Take a look at our free research report of analyst consensus for 856’s outlook.

2. Past Track Record: Has 856 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 856’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.