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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 begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Clifford Modern Living Holdings Limited (HKG:3686) is currently trading at a trailing P/E of 7, which is close to the industry average of 7.1. While 3686 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Check out our latest analysis for Clifford Modern Living Holdings
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in 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 3686
Price-Earnings Ratio = Price per share ÷ Earnings per share
3686 Price-Earnings Ratio = CN¥0.50 ÷ CN¥0.0723 = 7x
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 3686, 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. Clifford Modern Living Holdings Limited (HKG:3686) is trading with a trailing P/E of 7, which is close to the industry average of 7.1. This multiple is a median of profitable companies of 10 Industrials companies in HK including Chevalier International Holdings, Chongqing Machinery & Electric and Shanghai Industrial Holdings. One could put it like this: the market is pricing 3686 as if it is roughly average for 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 3686. 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 3686, 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 3686 to are fairly valued by the market. If this does not hold true, 3686’s lower P/E ratio may be because firms in our peer group are overvalued by the market.