Hebron Technology Co Ltd (NASDAQ:HEBT) is trading with a trailing P/E of 6.2x, which is lower than the industry average of 26.3x. While this makes HEBT 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. View our latest analysis for Hebron Technology
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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for HEBT
Price per share = 3.04
Earnings per share = 0.493
∴ Price-Earnings Ratio = 3.04 ÷ 0.493 = 6.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to HEBT, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
HEBT’s P/E of 6.2x is lower than its industry peers (26.3x), which implies that each dollar of HEBT’s earnings is being undervalued by investors. As such, our analysis shows that HEBT represents an under-priced stock.
A few caveats
However, before you rush out to buy HEBT, 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 HEBT. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with HEBT, then investors would naturally value HEBT at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with HEBT, investors would also value HEBT at a lower price since it is a lower growth investment. Both scenarios would explain why HEBT has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing HEBT to are fairly valued by the market. If this assumption is violated, HEBT's P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
Are you a shareholder? 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 HEBT 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.
Are you a potential investor? If you are considering investing in HEBT, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Hebron Technology for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
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.