Mineral Commodities Limited (ASX:MRC) trades with a trailing P/E of 5.4x, which is lower than the industry average of 11.1x. While this makes MRC appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Mineral Commodities
What you need to know about 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 MRC
Price-Earnings Ratio = Price per share ÷ Earnings per share
MRC Price-Earnings Ratio = 0.11 ÷ 0.015 = 5.4x
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 MRC, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since MRC's P/E of 5.4x is lower than its industry peers (11.1x), it means that investors are paying less than they should for each dollar of MRC's earnings. Therefore, according to this analysis, MRC is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that MRC is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to MRC, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with MRC, 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 MRC to are fairly valued by the market. If this is violated, MRC'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? 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 MRC 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 MRC, 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.