This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
China XLX Fertiliser Ltd (HKG:1866) is trading with a trailing P/E of 5.8x, which is lower than the industry average of 8.9x. While 1866 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Breaking down the P/E ratio
P/E is a popular ratio used for relative valuation. 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 1866
Price-Earnings Ratio = Price per share ÷ Earnings per share
1866 Price-Earnings Ratio = CN¥2.81 ÷ CN¥0.481 = 5.8x
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 1866, 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. 1866’s P/E of 5.8x is lower than its industry peers (8.9x), which implies that each dollar of 1866’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Chemicals companies in HK including China Sanjiang Fine Chemicals, Century Sunshine Group Holdings and China First Chemical Holdings. Therefore, according to this analysis, 1866 is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy 1866 immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 1866. 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 1866, 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 1866 to are fairly valued by the market. If this is violated, 1866’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 1866 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 1866’s future growth? Take a look at our free research report of analyst consensus for 1866’s outlook.
- Past Track Record: Has 1866 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 1866’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.