China Fire Safety Enterprise Group Limited (SEHK:445) trades with a trailing P/E of 57.7x, which is higher than the industry average of 15.1x. While this makes 445 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for China Fire Safety Enterprise Group
What you need to know about the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 445
Price per share = CN¥0.31
Earnings per share = CN¥0.005
∴ Price-Earnings Ratio = CN¥0.31 ÷ CN¥0.005 = 57.7x
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 445, 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 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.
At 57.7x, 445’s P/E is higher than its industry peers (15.1x). This implies that investors are overvaluing each dollar of 445’s earnings. Therefore, according to this analysis, 445 is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your 445 shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to 445. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with 445, then investors would naturally value 445 at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with 445, investors would also value 445 at a higher price since it is a higher growth investment. Both scenarios would explain why 445 has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing 445 to are fairly valued by the market. If this does not hold, there is a possibility that 445’s P/E is higher because firms in our peer group are being undervalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to 445. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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:
- 1. Financial Health: Is 445’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.
- 2. Past Track Record: Has 445 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 445’s historicals for more clarity.
- 3. 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.