This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.

Pak Tak International Limited (HKG:2668) is currently trading at a trailing P/E of 6.3x, which is lower than the industry average of 11.2x. 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. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.

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What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief 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 2668

Price-Earnings Ratio = Price per share ÷ Earnings per share

2668 Price-Earnings Ratio = HK$0.18 ÷ HK$0.0284 = 6.3x

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 2668, 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. 2668’s P/E of 6.3 is lower than its industry peers (11.2), which implies that each dollar of 2668’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Luxury companies in HK including Victory City International Holdings, Hosa International and Embry Holdings. One could put it like this: the market is pricing 2668 as if it is a weaker company than the average company in its industry.

Assumptions to be aware of

Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to 2668, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 2668, 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 2668 to are fairly valued by the market. If this does not hold, there is a possibility that 2668’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Since you may have already conducted your due diligence on 2668, the undervaluation of the stock may mean it is a good time to top up on 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. 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 urge you to complete your research by taking a look at the following:

1. Financial Health: Are 2668’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.

2. Past Track Record: Has 2668 been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of 2668’s historicals for more clarity.

3. 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 editorial-team@simplywallst.com.