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.
CCID Consulting Company Limited (HKG:8235) trades with a trailing P/E of 6.4x, which is lower than the industry average of 13.4x. While this makes 8235 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 8235
Price per share = CN¥0.19
Earnings per share = CN¥0.0305
∴ Price-Earnings Ratio = CN¥0.19 ÷ CN¥0.0305 = 6.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 8235, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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.
At 6.4x, 8235’s P/E is lower than its industry peers (13.4x). This implies that investors are undervaluing each dollar of 8235’s earnings. This multiple is a median of profitable companies of 20 IT companies in HK including EFT Solutions Holdings, Hi Sun Technology (China) and Green Leader Holdings Group. As such, our analysis shows that 8235 represents an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy 8235, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to 8235. 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 8235, then investors would naturally value 8235 at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with 8235, investors would also value 8235 at a lower price since it is a lower growth investment. Both scenarios would explain why 8235 has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing 8235 to are fairly valued by the market. If this assumption does not hold true, 8235’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on 8235, the undervaluation of the stock may mean it is a good time to top up on 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for 8235’s future growth? Take a look at our free research report of analyst consensus for 8235’s outlook.
- Past Track Record: Has 8235 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 8235’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 pass 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.