China New Borun Corporation (NYSE:BORN) trades with a trailing P/E of 3x, which is lower than the industry average of 23.2x. While this makes BORN 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. See our latest analysis for China New Borun
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 BORN
Price-Earnings Ratio = Price per share ÷ Earnings per share
BORN Price-Earnings Ratio = CN¥9.08 ÷ CN¥3.062 = 3x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to BORN, 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. Since BORN’s P/E of 3x is lower than its industry peers (23.2x), it means that investors are paying less than they should for each dollar of BORN’s earnings. Therefore, according to this analysis, BORN is an under-priced stock.
A few caveats
However, before you rush out to buy BORN, 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 BORN, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with BORN, 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 BORN to are fairly valued by the market. If this is violated, BORN’s P/E may be lower than its peers as they are actually overvalued by investors.
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.