Renmin Tianli Group Inc (NASDAQ:ABAC) trades with a trailing P/E of 29.1x, which is higher than the industry average of 26.5x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for ABAC
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for ABAC
Price per share = $3.16
Earnings per share = $0.109
∴ Price-Earnings Ratio = $3.16 ÷ $0.109 = 29.1x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ABAC, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
At 29.1x, ABAC’s P/E is higher than its industry peers (26.5x). This implies that investors are overvaluing each dollar of ABAC’s earnings. Therefore, according to this analysis, ABAC is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your ABAC shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to ABAC. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared riskier firms with ABAC, then investors would naturally value ABAC at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with ABAC, investors would also value ABAC at a higher price since it is a higher growth investment. Both scenarios would explain why ABAC has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing ABAC to are fairly valued by the market. If this does not hold, there is a possibility that ABAC’s P/E is higher because firms in our peer group are being undervalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on ABAC, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above.
Are you a potential investor? If you are considering investing in ABAC, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Renmin Tianli Group for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.