In This Article:
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.
Road King Infrastructure Limited (HKG:1098) trades with a trailing P/E of 4.1x, which is lower than the industry average of 5.7x. While this makes 1098 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.
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Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 1098
Price-Earnings Ratio = Price per share ÷ Earnings per share
1098 Price-Earnings Ratio = HK$13.4 ÷ HK$3.3 = 4.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to 1098, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 4.1, 1098’s P/E is lower than its industry peers (5.7). This implies that investors are undervaluing each dollar of 1098’s earnings. This multiple is a median of profitable companies of 25 Real Estate companies in HK including Top Spring International Holdings, Chinney Investments and Hon Kwok Land Investment Company. One could put it like this: the market is pricing 1098 as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to 1098. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with 1098, 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 1098 to are fairly valued by the market. If this does not hold, there is a possibility that 1098’s P/E is lower because our peer group is overvalued by the market.