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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.
Modern Dental Group Limited (HKG:3600) is currently trading at a trailing P/E of 10.2x, which is lower than the industry average of 20.8x. While 3600 might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, 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 Modern Dental Group
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 3600
Price-Earnings Ratio = Price per share ÷ Earnings per share
3600 Price-Earnings Ratio = HK$1.4 ÷ HK$0.137 = 10.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 3600, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. 3600’s P/E of 10.2 is lower than its industry peers (20.8), which implies that each dollar of 3600’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 11 Medical Equipment companies in HK including Beijing Enterprises Medical and Health Industry Group, China Isotope & Radiation and Yestar Healthcare Holdings. You can think of it like this: the market is suggesting that 3600 is a weaker business than the average comparable company.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 3600, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 3600, 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 3600 to are fairly valued by the market. If this does not hold, there is a possibility that 3600’s P/E is lower because our peer group is overvalued by the market.