Texhong Textile Group Limited (SEHK:2678) is trading with a trailing P/E of 8.8x, which is lower than the industry average of 13.2x. While this makes 2678 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Texhong Textile Group

Breaking down the Price-Earnings ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 2678

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

2678 Price-Earnings Ratio = CN¥11.13 ÷ CN¥1.259 = 8.8x

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 2678, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 2678’s P/E of 8.8x is lower than its industry peers (13.2x), which implies that each dollar of 2678’s earnings is being undervalued by investors. Therefore, according to this analysis, 2678 is an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy 2678, 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 2678, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 2678, 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 2678 to are fairly valued by the market. If this is violated, 2678’s P/E may be lower than its peers as they are actually overvalued by investors.

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 2678. 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 2678’s future growth? Take a look at our free research report of analyst consensus for 2678’s outlook.

2. Past Track Record: Has 2678 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 2678’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 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.