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.
Chasen Holdings Limited (SGX:5NV) trades with a trailing P/E of 4.6x, which is lower than the industry average of 11.9x. While this makes 5NV appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Demystifying 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 5NV
Price per share = SGD0.076
Earnings per share = SGD0.0165
∴ Price-Earnings Ratio = SGD0.076 ÷ SGD0.0165 = 4.6x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 5NV, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will 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 4.6x, 5NV’s P/E is lower than its industry peers (11.9x). This implies that investors are undervaluing each dollar of 5NV’s earnings. This multiple is a median of profitable companies of 11 Commercial Services companies in SG including Luxking Group Holdings, Leader Environmental Technologies and Dutech Holdings. Therefore, according to this analysis, 5NV is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy 5NV, 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 5NV. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing lower risk firms with 5NV, then 5NV’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 5NV. In this case, 5NV’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 5NV to are fairly valued by the market. If this assumption is violated, 5NV’s P/E may be lower than its peers because its peers are actually overvalued by investors.
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 5NV. 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 5NV’s future growth? Take a look at our free research report of analyst consensus for 5NV’s outlook.
- Past Track Record: Has 5NV 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 5NV’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.