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.
Yin He Holdings Limited (HKG:8260) trades with a trailing P/E of 16.3x, which is lower than the industry average of 21.4x. 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
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Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 8260
Price-Earnings Ratio = Price per share ÷ Earnings per share
8260 Price-Earnings Ratio = HK$0.72 ÷ HK$0.0441 = 16.3x
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 8260, 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. At 16.3x, 8260’s P/E is lower than its industry peers (21.4x). This implies that investors are undervaluing each dollar of 8260’s earnings. Since the Professional Services sector in HK 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 K W Nelson Interior Design and Contracting Group, C Cheng Holdings and KNK Holdings. As such, our analysis shows that 8260 represents an under-priced stock.
A few caveats
However, before you rush out to buy 8260, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to 8260, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 8260, 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 8260 to are fairly valued by the market. If this is violated, 8260’s P/E may be lower than its peers as they are actually overvalued by investors.