In This Article:
I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Lee and Man Paper Manufacturing Limited (HKG:2314) is trading with a trailing P/E of 5.1x, which is lower than the industry average of 9.1x. While this makes 2314 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Lee and Man Paper Manufacturing
Demystifying the P/E ratio
P/E is a popular ratio used for relative valuation. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for 2314
Price-Earnings Ratio = Price per share ÷ Earnings per share
2314 Price-Earnings Ratio = HK$6.64 ÷ HK$1.296 = 5.1x
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 2314, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since 2314’s P/E of 5.1 is lower than its industry peers (9.1), it means that investors are paying less for each dollar of 2314’s earnings. This multiple is a median of profitable companies of 5 Forestry companies in HK including Nine Dragons Paper (Holdings), Hong Wei (Asia) Holdings and Da Sen Holdings Group. You can think of it like this: the market is suggesting that 2314 is a weaker business than the average comparable company.
A few caveats
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to 2314, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 2314, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 2314 to are fairly valued by the market. If this is violated, 2314’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on 2314, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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: