Atlinks Group Limited (SEHK:8043) is currently trading at a trailing P/E of 25.7x, which is higher than the industry average of 19.6x. While this makes 8043 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Atlinks Group
What you need to know about the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 8043
Price per share = €0.05
Earnings per share = €0.002
∴ Price-Earnings Ratio = €0.05 ÷ €0.002 = 25.7x
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 8043, 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.
8043’s P/E of 25.7x is higher than its industry peers (19.6x), which implies that each dollar of 8043’s earnings is being overvalued by investors. Therefore, according to this analysis, 8043 is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that 8043 should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to 8043. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared lower growth firms with 8043, then 8043’s P/E would naturally be higher since investors would reward 8043’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with 8043, 8043’s P/E would again be higher since investors would reward 8043’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing 8043 to are fairly valued by the market. If this assumption does not hold true, 8043’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to 8043. 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 urge you to complete your research by taking a look at the following:
- Financial Health: Is 8043’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.