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China Galaxy Securities Co Ltd. (SEHK:6881) is currently trading at a trailing P/E of 10.2x, which is lower than the industry average of 14.1x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. 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 China Galaxy Securities
Breaking down the P/E ratio
P/E is a popular ratio used for relative valuation. 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 6881
Price-Earnings Ratio = Price per share ÷ Earnings per share
6881 Price-Earnings Ratio = CN¥4.03 ÷ CN¥0.394 = 10.2x
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 6881, 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. Since 6881’s P/E of 10.2x is lower than its industry peers (14.1x), it means that investors are paying less than they should for each dollar of 6881’s earnings. Therefore, according to this analysis, 6881 is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy 6881 immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 6881. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with 6881, 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 6881 to are fairly valued by the market. If this is violated, 6881’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 6881 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: