This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
China Resources Cement Holdings Limited (HKG:1313) is trading with a trailing P/E of 9.1, which is higher than the industry average of 8.3. Though this might seem to be a negative, 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.
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for 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 1313
Price-Earnings Ratio = Price per share ÷ Earnings per share
1313 Price-Earnings Ratio = HK$8.32 ÷ HK$0.918 = 9.1x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 1313, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 1313’s P/E of 9.1 is higher than its industry peers (8.3), which implies that each dollar of 1313’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 9 Basic Materials companies in HK including China Yu Tian Holdings, China National Building Material and West China Cement. You could also say that the market is suggesting that 1313 is a stronger business than the average comparable company.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to 1313. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where China Resources Cement Holdings Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. We should also be aware that the stocks we are comparing to 1313 may not be fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.
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 rebalance your portfolio and reduce your holdings in 1313. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for 1313’s future growth? Take a look at our free research report of analyst consensus for 1313’s outlook.
- Past Track Record: Has 1313 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 1313’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.