China Everbright Water Limited (SGX:U9E) is trading with a trailing P/E of 12.1x, which is lower than the industry average of 15.8x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for China Everbright Water
Demystifying the P/E ratio
P/E is a popular ratio used for relative valuation. 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.
P/E Calculation for U9E
Price-Earnings Ratio = Price per share ÷ Earnings per share
U9E Price-Earnings Ratio = HK$2.37 ÷ HK$0.196 = 12.1x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 U9E, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 12.1x, U9E’s P/E is lower than its industry peers (15.8x). This implies that investors are undervaluing each dollar of U9E’s earnings. As such, our analysis shows that U9E represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy U9E, 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 U9E, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with U9E, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing U9E to are fairly valued by the market. If this is violated, U9E’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on U9E, 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 U9E’s future growth? Take a look at our free research report of analyst consensus for U9E’s outlook.
- Financial Health: Is U9E’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 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.