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 begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Ronshine China Holdings Limited (HKG:3301) trades with a trailing P/E of 6.4x, which is higher than the industry average of 6.3x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, 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.
See our latest analysis for Ronshine China Holdings
What you need to know about the P/E 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 3301
Price-Earnings Ratio = Price per share ÷ Earnings per share
3301 Price-Earnings Ratio = CN¥7.88 ÷ CN¥1.223 = 6.4x
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 3301, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. 3301’s P/E of 6.4x is higher than its industry peers (6.3x), which implies that each dollar of 3301’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Real Estate companies in HK including Fullsun International Holdings Group, Redsun Properties Group and Top Spring International Holdings. Therefore, according to this analysis, 3301 is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your 3301 shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to 3301, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 3301, 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 3301 to are fairly valued by the market. If this does not hold true, 3301’s lower P/E ratio may be because firms in our peer group are overvalued by the market.