This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Genertec Universal Medical Group Company Limited (HKG:2666) trades with a trailing P/E of 7.1x, which is lower than the industry average of 33x. While this makes 2666 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
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. 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 2666
Price per share = CN¥5.39
Earnings per share = CN¥0.760
∴ Price-Earnings Ratio = CN¥5.39 ÷ CN¥0.760 = 7.1x
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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 2666, such as size and country of operation. 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.
2666’s P/E of 7.1x is lower than its industry peers (33x), which implies that each dollar of 2666’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 23 Healthcare companies in HK including China Pioneer Pharma Holdings, Kingworld Medicines Group and China NT Pharma Group. As such, our analysis shows that 2666 represents an under-priced stock.
A few caveats
Before you jump to the conclusion that 2666 represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to 2666. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing lower risk firms with 2666, then 2666’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with 2666. In this case, 2666’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 2666 to are fairly valued by the market. If this assumption is violated, 2666’s P/E may be lower than its peers because its peers are actually overvalued by investors.
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 add more of 2666 to your portfolio. 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 2666’s future growth? Take a look at our free research report of analyst consensus for 2666’s outlook.
- Past Track Record: Has 2666 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 2666’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.