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 learn about the link between company’s fundamentals and stock market performance.
Hailan Holdings Limited (HKG:2278) is trading with a trailing P/E of 3.9x, which is lower than the industry average of 5.6x. 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 explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 2278
Price-Earnings Ratio = Price per share ÷ Earnings per share
2278 Price-Earnings Ratio = CN¥3.84 ÷ CN¥0.988 = 3.9x
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 2278, 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. 2278’s P/E of 3.9 is lower than its industry peers (5.6), which implies that each dollar of 2278’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 25 Real Estate companies in HK including Fullsun International Holdings Group, Chinney Investments and Top Spring International Holdings. One could put it like this: the market is pricing 2278 as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
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 2278. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with 2278, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing 2278 to are fairly valued by the market. If this does not hold, there is a possibility that 2278’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of 2278 to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for 2278’s future growth? Take a look at our free research report of analyst consensus for 2278’s outlook.
- Financial Health: Are 2278’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.