I am writing today to help inform people who are new to 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.
Wing Tai Holdings Limited (SGX:W05) is currently trading at a trailing P/E of 16.2x, which is higher than the industry average of 11.1x. While this makes W05 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. 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.
See our latest analysis for Wing Tai Holdings
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 W05
Price-Earnings Ratio = Price per share ÷ Earnings per share
W05 Price-Earnings Ratio = SGD1.98 ÷ SGD0.122 = 16.2x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to W05, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since W05’s P/E of 16.2x is higher than its industry peers (11.1x), it means that investors are paying more than they should for each dollar of W05’s earnings. This multiple is a median of profitable companies of 24 Real Estate companies in SG including Heeton Holdings, Hong Fok and CWG International. As such, our analysis shows that W05 represents an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your W05 shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to W05, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with W05, 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 W05 to are fairly valued by the market. If this does not hold true, W05’s lower P/E ratio may be because firms in our peer group are overvalued by the market.