This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
China Life Insurance Company Limited (HKG:2628) trades on a trailing P/E of 11.8. This isn’t too far from the industry average (which is 11.8). While this makes 2628 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
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. 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 2628
Price-Earnings Ratio = Price per share ÷ Earnings per share
2628 Price-Earnings Ratio = CN¥15.04 ÷ CN¥1.276 = 11.8x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 2628, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. China Life Insurance Company Limited (HKG:2628) is currently trading at a trailing P/E of 11.8, which is close to the industry average of 11.8. This multiple is a median of profitable companies of 7 Insurance companies in HK including People’s Insurance Company (Group) of China, PICC Property and Casualty and China Taiping Insurance Holdings. You can think of it like this: the market is suggesting that 2628 has similar prospects to its peers in the same industry.
Assumptions to watch out for
However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to 2628. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with 2628, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 2628 to are fairly valued by the market. If this is violated, 2628’s P/E may be lower than its peers as they are actually overvalued by investors.
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 add more of 2628 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. 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 2628’s future growth? Take a look at our free research report of analyst consensus for 2628’s outlook.
- Past Track Record: Has 2628 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 2628’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 email@example.com.