SORL Auto Parts Inc (NASDAQ:SORL) is currently trading at a trailing P/E of 3.3x, which is lower than the industry average of 18.5x. While SORL 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 SORL
What you need to know about the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for SORL
Price per share = 4.18
Earnings per share = 1.264
∴ Price-Earnings Ratio = 4.18 ÷ 1.264 = 3.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as SORL, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 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.
At 3.3x, SORL’s P/E is lower than its industry peers (18.5x). This implies that investors are undervaluing each dollar of SORL’s earnings. Therefore, according to this analysis, SORL is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy SORL immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to SORL. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with SORL, then investors would naturally value SORL at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with SORL, investors would also value SORL at a lower price since it is a lower growth investment. Both scenarios would explain why SORL has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing SORL to are fairly valued by the market. If this assumption is violated, SORL'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 SORL 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 SORL has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
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 SORL Auto Parts 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.