Yirendai Ltd (NYSE:YRD) is currently trading at a trailing P/E of 12x, which is lower than the industry average of 14.1x. While YRD 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 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 Yirendai
What you need to know about the P/E 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 YRD
Price-Earnings Ratio = Price per share ÷ Earnings per share
YRD Price-Earnings Ratio = CN¥260.68 ÷ CN¥21.712 = 12x
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 YRD, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. YRD’s P/E of 12x is lower than its industry peers (14.1x), which implies that each dollar of YRD’s earnings is being undervalued by investors. As such, our analysis shows that YRD represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy YRD, 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 YRD, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with YRD, 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 YRD to are fairly valued by the market. If this does not hold, there is a possibility that YRD’s P/E is lower because our peer group is overvalued by the market.
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.