CITIC Dameng Holdings Limited (SEHK:1091) trades with a trailing P/E of 14.4x, which is higher than the industry average of 12.3x. While this makes 1091 appear like a stock to avoid or sell if you own it, 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. View our latest analysis for CITIC Dameng Holdings
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 1091
Price-Earnings Ratio = Price per share ÷ Earnings per share
1091 Price-Earnings Ratio = HK$0.5 ÷ HK$0.035 = 14.4x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 1091, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since 1091’s P/E of 14.4x is higher than its industry peers (12.3x), it means that investors are paying more than they should for each dollar of 1091’s earnings. As such, our analysis shows that 1091 represents an over-priced stock.
A few caveats
Before you jump to the conclusion that 1091 should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to 1091, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with 1091, 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 1091 to are fairly valued by the market. If this does not hold, there is a possibility that 1091’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on 1091, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above.