I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Great Eastern Holdings Limited (SGX:G07) is trading with a trailing P/E of 10.5x, which is lower than the industry average of 15.4x. While this makes G07 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
See our latest analysis for Great Eastern Holdings
Demystifying 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 G07
Price-Earnings Ratio = Price per share ÷ Earnings per share
G07 Price-Earnings Ratio = SGD27.3 ÷ SGD2.597 = 10.5x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as G07, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. G07’s P/E of 10.5 is lower than its industry peers (15.4), which implies that each dollar of G07’s earnings is being undervalued by investors. Since the Insurance sector in SG is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as United Overseas Insurance, Singapore Reinsurance and . One could put it like this: the market is pricing G07 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 G07. 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 G07, 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 G07 to are fairly valued by the market. If this does not hold true, G07’s lower P/E ratio may be because firms in our peer group are overvalued by the market.