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 learn about the link between company’s fundamentals and stock market performance.
China Best Group Holding Limited (HKG:370) trades with a trailing P/E of 32.3x, which is higher than the industry average of 11.2x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 370
Price per share = HK$0.11
Earnings per share = HK$0.00338
∴ Price-Earnings Ratio = HK$0.11 ÷ HK$0.00338 = 32.3x
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 370, 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.
Since 370’s P/E of 32.3x is higher than its industry peers (11.2x), it means that investors are paying more than they should for each dollar of 370’s earnings. This multiple is a median of profitable companies of 16 Retail Distributors companies in HK including Sparkle Roll Group, Eminence Enterprise and G.A. Holdings. As such, our analysis shows that 370 represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that 370 should be banished from your portfolio, 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 370. 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 370, then 370’s P/E would naturally be higher since investors would reward 370’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with 370, 370’s P/E would again be higher since investors would reward 370’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing 370 to are fairly valued by the market. If this assumption does not hold true, 370’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 370, 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 370’s future growth? Take a look at our free research report of analyst consensus for 370’s outlook.
- Past Track Record: Has 370 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 370’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.