This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.
Country Garden Services Holdings Company Limited (HKG:6098) trades with a trailing P/E of 43x, which is higher than the industry average of 16.7x. While 6098 might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
What you need to know about 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for 6098
Price per share = CN¥11.53
Earnings per share = CN¥0.268
∴ Price-Earnings Ratio = CN¥11.53 ÷ CN¥0.268 = 43x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 6098, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will 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.
Since 6098’s P/E of 43x is higher than its industry peers (16.7x), it means that investors are paying more than they should for each dollar of 6098’s earnings. This multiple is a median of profitable companies of 25 Commercial Services companies in HK including Neway Group Holdings, REF Holdings and Beijing Enterprises Environment Group. Therefore, according to this analysis, 6098 is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your 6098 shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 6098. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing riskier firms with 6098, then 6098’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with 6098. In this case, 6098’s P/E would be higher since investors would also reward 6098’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 6098 to are fairly valued by the market. If this assumption does not hold true, 6098’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
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 6098. 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 6098’s future growth? Take a look at our free research report of analyst consensus for 6098’s outlook.
- Financial Health: Are 6098’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 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.