AeroCentury Corp (AMEX:ACY) is currently trading at a trailing P/E of 13.8x, which is lower than the industry average of 23.8x. While ACY might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for AeroCentury

What you need to know about the P/E ratio

P/E is a popular ratio used for relative valuation. 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 ACY

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

ACY Price-Earnings Ratio = 13.5 ÷ 0.975 = 13.8x

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 ACY, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since ACY’s P/E of 13.8x is lower than its industry peers (23.8x), it means that investors are paying less than they should for each dollar of ACY’s earnings. Therefore, according to this analysis, ACY is an under-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that ACY is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to ACY. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with ACY, 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 ACY to are fairly valued by the market. If this does not hold, there is a possibility that ACY’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to ACY. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.