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This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Bank of Qingdao Co Ltd (HKG:3866) is currently trading at a trailing P/E of 11.2x, which is higher than the industry average of 6.1x. While 3866 might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
Check out our latest analysis for Bank of Qingdao
Breaking down the Price-Earnings 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 3866
Price-Earnings Ratio = Price per share ÷ Earnings per share
3866 Price-Earnings Ratio = CN¥5.26 ÷ CN¥0.468 = 11.2x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 3866, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 3866’s P/E of 11.2x is higher than its industry peers (6.1x), which implies that each dollar of 3866’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Banks companies in HK including Harbin Bank, Shengjing Bank and Bank of Chongqing. Therefore, according to this analysis, 3866 is an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your 3866 shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 3866, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 3866, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing 3866 to are fairly valued by the market. If this does not hold true, 3866’s lower P/E ratio may be because firms in our peer group are overvalued by the market.