Desane Group Holdings Limited (ASX:DGH) is trading with a trailing P/E of 10x, which is lower than the industry average of 12.3x. 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. 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. View our latest analysis for Desane Group Holdings

Breaking down the Price-Earnings 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.

Formula

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

P/E Calculation for DGH

Price per share = 1.36

Earnings per share = 0.136

∴ Price-Earnings Ratio = 1.36 ÷ 0.136 = 10x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as DGH, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.

At 10x, DGH’s P/E is lower than its industry peers (12.3x). This implies that investors are undervaluing each dollar of DGH’s earnings. Therefore, according to this analysis, DGH is an under-priced stock.

A few caveats

While our conclusion might prompt you to buy DGH immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to DGH. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing lower risk firms with DGH, then DGH’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with DGH. In this case, DGH’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing DGH to are fairly valued by the market. If this does not hold, there is a possibility that DGH’s P/E is lower because firms in our peer group are being overvalued by the market.