This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
China XD Plastics Company Limited (NASDAQ:CXDC) is trading with a trailing P/E of 5.7x, which is lower than the industry average of 12.9x. While CXDC 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in 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 CXDC
Price-Earnings Ratio = Price per share ÷ Earnings per share
CXDC Price-Earnings Ratio = $3.45 ÷ $0.607 = 5.7x
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 CXDC, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. CXDC’s P/E of 5.7x is lower than its industry peers (12.9x), which implies that each dollar of CXDC’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Auto Components companies in US including D Mecatronics, SORL Auto Parts and American Axle & Manufacturing Holdings. Therefore, according to this analysis, CXDC is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that CXDC is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to CXDC, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with CXDC, 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 CXDC to are fairly valued by the market. If this does not hold true, CXDC’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to CXDC. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for CXDC’s future growth? Take a look at our free research report of analyst consensus for CXDC’s outlook.
- Past Track Record: Has CXDC 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 CXDC’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.