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.
Hanwell Holdings Limited (SGX:DM0) is trading with a trailing P/E of 7.8x, which is lower than the industry average of 14.5x. While this makes DM0 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 DM0
Price-Earnings Ratio = Price per share ÷ Earnings per share
DM0 Price-Earnings Ratio = SGD0.22 ÷ SGD0.0281 = 7.8x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to DM0, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. DM0’s P/E of 7.8 is lower than its industry peers (14.5), which implies that each dollar of DM0’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 16 Food companies in SG including Oceanus Group, Sino Grandness Food Industry Group and JB Foods. You can think of it like this: the market is suggesting that DM0 is a weaker business than the average comparable company.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to DM0, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with DM0, 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 DM0 to are fairly valued by the market. If this does not hold, there is a possibility that DM0’s P/E is lower because our peer group is 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 DM0. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for DM0’s future growth? Take a look at our free research report of analyst consensus for DM0’s outlook.
- Past Track Record: Has DM0 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 DM0’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.