Should You Be Tempted To Buy Cosmos Machinery Enterprises Limited (HKG:118) Because Of Its PE Ratio?

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 begin learning about how to value company based on its current earnings and what are the drawbacks of this method.

Cosmos Machinery Enterprises Limited (HKG:118) trades with a trailing P/E of 3.8x, which is lower than the industry average of 10.3x. While this makes 118 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.

See our latest analysis for Cosmos Machinery Enterprises

What you need to know about the P/E ratio

SEHK:118 PE PEG Gauge September 13th 18
SEHK:118 PE PEG Gauge September 13th 18

P/E is a popular ratio used for relative valuation. 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 118

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

118 Price-Earnings Ratio = HK$0.47 ÷ HK$0.122 = 3.8x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as 118, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 118’s P/E of 3.8 is lower than its industry peers (10.3), which implies that each dollar of 118’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Machinery companies in HK including CW Group Holdings, Wuxi Sunlit Science and Technology and Asia Tele-Net and Technology. One could put it like this: the market is pricing 118 as if it is a weaker company than the average company in its industry.

Assumptions to be aware of

However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to 118. 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 118, 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 118 to are fairly valued by the market. If this does not hold true, 118’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to 118. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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:

  1. Financial Health: Are 118’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 118 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 118’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.