The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Lee and Man Paper Manufacturing Limited (HKG:2314) is trading with a trailing P/E of 5.9, which is lower than the industry average of 6.8. Although some investors might think this is a real positive, that might change once you understand the assumptions behind the P/E. 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 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 2314
Price per share = HK$7.68
Earnings per share = HK$1.296
∴ Price-Earnings Ratio = HK$7.68 ÷ HK$1.296 = 5.9x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against 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 2314, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
At 5.9, 2314’s P/E is lower than its industry peers (6.8). This implies that investors are undervaluing each dollar of 2314’s earnings. This multiple is a median of profitable companies of 5 Forestry companies in HK including Nine Dragons Paper (Holdings), Da Sen Holdings Group and Hong Wei (Asia) Holdings. You can think of it like this: the market is suggesting that 2314 is a weaker business than the average comparable company.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two important assertions. The first is that our “similar companies” are actually similar to 2314. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with 2314, then investors would naturally value 2314 at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with 2314, investors would also value 2314 at a lower price since it is a lower growth investment. Both scenarios would explain why 2314 has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing 2314 to are fairly valued by the market. If this does not hold, there is a possibility that 2314’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to 2314. 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:
- Future Outlook: What are well-informed industry analysts predicting for 2314’s future growth? Take a look at our free research report of analyst consensus for 2314’s outlook.
- Past Track Record: Has 2314 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 2314’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 email@example.com.