China Mengniu Dairy Company Limited (SEHK:2319) is currently trading at a trailing P/E of 43.4x, which is higher than the industry average of 14.3x. While 2319 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. See our latest analysis for China Mengniu Dairy

Demystifying 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 2319

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

2319 Price-Earnings Ratio = CN¥22.82 ÷ CN¥0.526 = 43.4x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to 2319, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 2319’s P/E of 43.4x is higher than its industry peers (14.3x), which implies that each dollar of 2319’s earnings is being overvalued by investors. As such, our analysis shows that 2319 represents an over-priced stock.

A few caveats

Before you jump to the conclusion that 2319 should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to 2319. 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 2319, 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 2319 to are fairly valued by the market. If this does not hold, there is a possibility that 2319’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 2319, the overvaluation of the stock may mean it is a good time to reduce 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. Future Outlook: What are well-informed industry analysts predicting for 2319’s future growth? Take a look at our free research report of analyst consensus for 2319’s outlook.

2. Past Track Record: Has 2319 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 2319’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 pass 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.