I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Xinming China Holdings Limited (HKG:2699) trades with a trailing P/E of 7.2x, which is higher than the industry average of 6.4x. While 2699 might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, 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 Xinming China Holdings
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 2699
Price-Earnings Ratio = Price per share ÷ Earnings per share
2699 Price-Earnings Ratio = CN¥0.92 ÷ CN¥0.128 = 7.2x
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 2699, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. 2699’s P/E of 7.2x is higher than its industry peers (6.4x), which implies that each dollar of 2699’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. As such, our analysis shows that 2699 represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your 2699 shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to 2699. 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 2699, 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 2699 to are fairly valued by the market. If this is violated, 2699’s P/E may be lower than its peers as they are actually overvalued by investors.