In This Article:
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.
China Zheshang Bank Co Ltd (HKG:2016) is trading with a trailing P/E of 6.1x, which is lower than the industry average of 6.1x. While this makes 2016 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Check out our latest analysis for China Zheshang Bank
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. 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.
P/E Calculation for 2016
Price-Earnings Ratio = Price per share ÷ Earnings per share
2016 Price-Earnings Ratio = CN¥3.5 ÷ CN¥0.574 = 6.1x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 2016, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use.
Assumptions to be aware of
While our conclusion might prompt you to buy 2016 immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 2016, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with 2016, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing 2016 to are fairly valued by the market. If this is violated, 2016’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of 2016 to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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: