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 start learning about core concepts of fundamental analysis on practical examples from today’s market.
China Development Bank Financial Leasing Co Ltd (HKG:1606) is currently trading at a trailing P/E of 7.9, which is close to the industry average of 8.2. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Breaking down 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 1606
Price-Earnings Ratio = Price per share ÷ Earnings per share
1606 Price-Earnings Ratio = CN¥1.22 ÷ CN¥0.155 = 7.9x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 1606, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. China Development Bank Financial Leasing Co Ltd (HKG:1606) is trading with a trailing P/E of 7.9, which is close to the industry average of 8.2. This multiple is a median of profitable companies of 18 Diversified Financial companies in HK including G-Resources Group, Min Xin Holdings and Far East Horizon. One could put it like this: the market is pricing 1606 as if it is roughly average for its industry.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to 1606, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 1606, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing 1606 to are fairly valued by the market. If this does not hold, there is a possibility that 1606’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on 1606, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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 1606’s future growth? Take a look at our free research report of analyst consensus for 1606’s outlook.
- Financial Health: Are 1606’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- 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 email@example.com.