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.
Fountain Set (Holdings) Limited (HKG:420) trades with a trailing P/E of 8.7x, which is lower than the industry average of 11.6x. 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. 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 Fountain Set (Holdings)
Breaking down the Price-Earnings 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 420
Price-Earnings Ratio = Price per share ÷ Earnings per share
420 Price-Earnings Ratio = HK$1.09 ÷ HK$0.126 = 8.7x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 420, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since 420’s P/E of 8.7 is lower than its industry peers (11.6), it means that investors are paying less for each dollar of 420’s earnings. This multiple is a median of profitable companies of 25 Luxury companies in HK including Hingtex Holdings, Hosa International and Victory City International Holdings. One could put it like this: the market is pricing 420 as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to 420. 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 420, 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 420 to are fairly valued by the market. If this is violated, 420’s P/E may be lower than its peers as they are actually overvalued by investors.