This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Bank of Zhengzhou Co Ltd (HKG:6196) is currently trading at a trailing P/E of 4.8, which is lower than the industry average of 6.1. While this makes 6196 appear like a good 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.
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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for 6196
Price per share = CN¥3.91
Earnings per share = CN¥0.822
∴ Price-Earnings Ratio = CN¥3.91 ÷ CN¥0.822 = 4.8x
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 6196, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
6196’s P/E of 4.8 is lower than its industry peers (6.1), which implies that each dollar of 6196’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Banks companies in HK including Shengjing Bank, Harbin Bank and Bank of Chongqing. One could put it like this: the market is pricing 6196 as if it is a weaker company than the average company in its industry.
A few caveats
However, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to 6196. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with 6196, then investors would naturally value 6196 at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with 6196, investors would also value 6196 at a lower price since it is a lower growth investment. Both scenarios would explain why 6196 has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing 6196 to are fairly valued by the market. If this assumption does not hold true, 6196’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on 6196, the undervaluation of the stock may mean it is a good time to top up on 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. 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 6196’s future growth? Take a look at our free research report of analyst consensus for 6196’s outlook.
- Past Track Record: Has 6196 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 6196’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.