The content of this article will benefit those of you who are starting to educate yourself about investing in 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.
Aluminum Corporation of China Limited (HKG:2600) is trading with a trailing P/E of 32.3, which is higher than the industry average of 7.9. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying 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. 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 2600
Price-Earnings Ratio = Price per share ÷ Earnings per share
2600 Price-Earnings Ratio = CN¥2.82 ÷ CN¥0.0874 = 32.3x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 2600, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 32.3, 2600’s P/E is higher than its industry peers (7.9). This implies that investors are overvaluing each dollar of 2600’s earnings. This multiple is a median of profitable companies of 25 Metals and Mining companies in HK including Hong Kong Finance Investment Holding Group, IRC and E-Commodities Holdings. You could also say that the market is suggesting that 2600 is a stronger business than the average comparable company.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. Firstly, that our peer group contains companies that are similar to 2600. If this isn’t the case, the difference in P/E could be due to other factors. For example, if Aluminum Corporation of China Limited is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with 2600 are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
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 rebalance your portfolio and reduce your holdings in 2600. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for 2600’s future growth? Take a look at our free research report of analyst consensus for 2600’s outlook.
- Past Track Record: Has 2600 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 2600’s historicals for more clarity.
- 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 firstname.lastname@example.org.