This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Xinyuan Real Estate Co Ltd (NYSE:XIN) is currently trading at a trailing P/E of 8.6, which is lower than the industry average of 19.4. Although some investors might think this is a real positive, that might change once you understand the assumptions behind the P/E. 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
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 XIN
Price per share = $3.96
Earnings per share = $0.462
∴ Price-Earnings Ratio = $3.96 ÷ $0.462 = 8.6x
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 XIN, 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 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.
XIN’s P/E of 8.6 is lower than its industry peers (19.4), which implies that each dollar of XIN’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Real Estate companies in US including Sunrise Real Estate Group, Altisource Portfolio Solutions and Kaanapali Land. One could put it like this: the market is pricing XIN as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to XIN. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with XIN, then investors would naturally value XIN at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with XIN, investors would also value XIN at a lower price since it is a lower growth investment. Both scenarios would explain why XIN has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing XIN to are fairly valued by the market. If this assumption does not hold true, XIN’s lower P/E ratio may be 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 XIN. 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:
- Future Outlook: What are well-informed industry analysts predicting for XIN’s future growth? Take a look at our free research report of analyst consensus for XIN’s outlook.
- Past Track Record: Has XIN 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 XIN’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.