Highpower International Inc (NASDAQ:HPJ) trades with a trailing P/E of 7.2x, which is lower than the industry average of 22.5x. While HPJ 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. View our latest analysis for Highpower International
Demystifying 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 HPJ
Price-Earnings Ratio = Price per share ÷ Earnings per share
HPJ Price-Earnings Ratio = 5.35 ÷ 0.746 = 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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to HPJ, 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. HPJ’s P/E of 7.2x is lower than its industry peers (22.5x), which implies that each dollar of HPJ’s earnings is being undervalued by investors. As such, our analysis shows that HPJ represents an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy HPJ immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to HPJ. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with HPJ, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing HPJ to are fairly valued by the market. If this does not hold, there is a possibility that HPJ’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on HPJ, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above.
Are you a potential investor? If HPJ has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Highpower International for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
To help readers see pass 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.