HSBC Holdings plc (NYSE:HSBC) trades with a trailing P/E of 35.3x, which is higher than the industry average of 17.8x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for HSBC Holdings

Demystifying the P/E ratio

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 HSBC

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

HSBC Price-Earnings Ratio = $9.82 ÷ $0.278 = 35.3x

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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to HSBC, 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. Since HSBC’s P/E of 35.3x is higher than its industry peers (17.8x), it means that investors are paying more than they should for each dollar of HSBC’s earnings. Therefore, according to this analysis, HSBC is an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your HSBC shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to HSBC, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with HSBC, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing HSBC to are fairly valued by the market. If this is violated, HSBC’s P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on HSBC, 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.

Are you a potential investor? If HSBC has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on HSBC Holdings for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

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.