Eildon Capital Limited (ASX:EDC) is trading with a trailing P/E of 6.7x, which is lower than the industry average of 21.6x. 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 explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Eildon Capital

Breaking down the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for EDC

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

EDC Price-Earnings Ratio = 1.06 ÷ 0.159 = 6.7x

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 EDC, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. EDC’s P/E of 6.7x is lower than its industry peers (21.6x), which implies that each dollar of EDC’s earnings is being undervalued by investors. As such, our analysis shows that EDC represents an under-priced stock.

Assumptions to watch out for

However, before you rush out to buy EDC, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to EDC, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with EDC, 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 EDC to are fairly valued by the market. If this does not hold, there is a possibility that EDC’s P/E is lower because our peer group is overpriced by the market.

What this means for you:

Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of EDC to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.

Are you a potential investor? If you are considering investing in EDC, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.