Wharf Real Estate Investment Company Limited (SEHK:1997) is trading with a trailing P/E of 11x, which is higher than the industry average of 7.3x. While this makes 1997 appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Wharf Real Estate Investment
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 1997
Price-Earnings Ratio = Price per share ÷ Earnings per share
1997 Price-Earnings Ratio = HK$62.6 ÷ HK$5.671 = 11x
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 1997, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 1997’s P/E of 11x is higher than its industry peers (7.3x), which implies that each dollar of 1997’s earnings is being overvalued by investors. As such, our analysis shows that 1997 represents an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your 1997 shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 1997, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 1997, 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 1997 to are fairly valued by the market. If this is violated, 1997’s P/E may be lower than its peers as they are actually overvalued by investors.
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 1997. 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 1997’s future growth? Take a look at our free research report of analyst consensus for 1997’s outlook.
- Financial Health: Is 1997’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- 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 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.