This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.

Yip’s Chemical Holdings Limited (HKG:408) is currently trading at a trailing P/E of 7.2x, which is lower than the industry average of 9.1x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for.

View our latest analysis for Yip’s Chemical Holdings

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 408

Price-Earnings Ratio = Price per share ÷ Earnings per share

408 Price-Earnings Ratio = HK$2.62 ÷ HK$0.362 = 7.2x

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 408, 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. At 7.2, 408’s P/E is lower than its industry peers (9.1). This implies that investors are undervaluing each dollar of 408’s earnings. This multiple is a median of profitable companies of 24 Chemicals companies in HK including China Sanjiang Fine Chemicals, Century Sunshine Group Holdings and China First Chemical Holdings. You can think of it like this: the market is suggesting that 408 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. Firstly, our peer group contains companies that are similar to 408. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with 408, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing 408 to are fairly valued by the market. If this does not hold, there is a possibility that 408’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Since you may have already conducted your due diligence on 408, 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 urge you to complete your research by taking a look at the following:

1. Future Outlook: What are well-informed industry analysts predicting for 408’s future growth? Take a look at our free research report of analyst consensus for 408’s outlook.

2. Past Track Record: Has 408 been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of 408’s historicals for more clarity.

3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.