I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
icentury Holding Limited (HKG:8507) trades with a trailing P/E of 38.3x, which is higher than the industry average of 11.2x. While this makes 8507 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.
Breaking down the P/E ratio
P/E is a popular ratio used for relative valuation. 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 8507
Price per share = HK$0.35
Earnings per share = HK$0.00914
∴ Price-Earnings Ratio = HK$0.35 ÷ HK$0.00914 = 38.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 8507, such as capital structure and profitability. 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.
8507’s P/E of 38.3x is higher than its industry peers (11.2x), which implies that each dollar of 8507’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Luxury companies in HK including Hosa International, Victory City International Holdings and Embry Holdings. Therefore, according to this analysis, 8507 is an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your 8507 shares immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to 8507. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared lower growth firms with 8507, then 8507’s P/E would naturally be higher since investors would reward 8507’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with 8507, 8507’s P/E would again be higher since investors would reward 8507’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing 8507 to are fairly valued by the market. If this assumption does not hold true, 8507’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:
Since you may have already conducted your due diligence on 8507, 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. 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 8507’s future growth? Take a look at our free research report of analyst consensus for 8507’s outlook.
- Financial Health: Are 8507’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 email@example.com.