The price-earnings ratio is a widely used metric for valuing stocks.
At the moment, the stocks in the Hang Seng Index have an average P/E ratio of 9.7 times, compared with an average 12.8 times over the last decade.
Based on the P/E ratio, it would seem that the Hong Kong market is quite cheap.
Chow Tai Fook Jewellery Group Ltd. (01929.HK) has a P/E ratio of 11.1 times, and Sa Sa International Holdings Ltd. (00178.HK) has a ratio of 9.2 times. Those ratios are at attractive levels.
However, the companies’ interim results slumped by nearly 50 percent.
Their P/E ratios could double next year if the trend continues.
So, are those stocks worth buying?
If their earnings fail to improve next year, that would drive up their P/E ratio.
So, the stocks face further downside risk.
Meanwhile, many analysts have pointed out that mainland Chinese banking stocks have P/E ratios of only 5-6 times at present, and they think there is limited room for a further drop.
The banking sector is the most sensitive to the economic cycle.
The non-performing loans of Chinese banks have risen for 15 straight quarters to over 1.2 trillion yuan (US$188 billion) amid slowing economic growth.
China’s economy has yet to show sign of a turnaround, and a weaker renminbi could weigh on banks’ earnings, which are due to be announced in March.
If earnings continue to decline, that would drive up their P/E ratios and put pressure on the stocks’ prices.
So, a low P/E ratio should not become a sole reason for buying.
“What is rational is actual and what is actual is rational,” German philosopher Georg Wilhelm Friedrich Hegel said.
That may sound like nonsense in the investment world, but investors should always think about the future rather than the present.
The US Federal Reserve is unlikely to hike interest rates aggressively.
However, that could change if US households’ income and rents falls along with slower economic growth.
What seems like a reasonable price at present does not mean that much.
The P/E ratio of an internet giant like Google Inc. is high at 36 times. Is that expensive?
Valuation tools and financial terms are intended to help you in making your investments rather than control you.
You might make mistakes if you rely too much on experience or investment tools.
Investment is an art, not a science.
Investors should predict future trends by themselves after understanding the formulas, and that’s much more important than the formulas themselves.
This article appeared in the Hong Kong Economic Journal on Dec. 4.
Translation by Julie Zhu
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