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.
Guangzhou Rural Commercial Bank Co Ltd (HKG:1551) is currently trading at a trailing P/E of 7.2x, which is higher than the industry average of 6.1x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. 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 Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 1551
Price-Earnings Ratio = Price per share ÷ Earnings per share
1551 Price-Earnings Ratio = CN¥4.21 ÷ CN¥0.582 = 7.2x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 1551, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 1551’s P/E of 7.2x is higher than its industry peers (6.1x), which implies that each dollar of 1551’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 24 Banks companies in HK including Shengjing Bank, Harbin Bank and Bank of Chongqing. Therefore, according to this analysis, 1551 is an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your 1551 shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to 1551. 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 1551, 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 1551 to are fairly valued by the market. If this is violated, 1551’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to 1551. 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 1551’s future growth? Take a look at our free research report of analyst consensus for 1551’s outlook.
- Past Track Record: Has 1551 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 1551’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.