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.
Anxian Yuan China Holdings Limited (HKG:922) is currently trading at a trailing P/E of 15x, which is lower than the industry average of 22.5x. While this makes 922 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in 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 922
Price-Earnings Ratio = Price per share ÷ Earnings per share
922 Price-Earnings Ratio = HK$0.35 ÷ HK$0.0236 = 15x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 922, 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. Since 922’s P/E of 15 is lower than its industry peers (22.5), it means that investors are paying less for each dollar of 922’s earnings. This multiple is a median of profitable companies of 24 Consumer Services companies in HK including Heng Sheng Holdings, China Chunlai Education Group and Water Oasis Group. One could put it like this: the market is pricing 922 as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
However, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to 922, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 922, 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 922 to are fairly valued by the market. If this does not hold true, 922’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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 922 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 922’s future growth? Take a look at our free research report of analyst consensus for 922’s outlook.
- Past Track Record: Has 922 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 922’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.