IVE Group Limited (ASX:IGL) trades with a trailing P/E of 18.3x, which is higher than the industry average of 17.2x. 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 explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for IVE Group

Breaking down 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 IGL

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

IGL Price-Earnings Ratio = 2.1 ÷ 0.115 = 18.3x

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 IGL, 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 IGL's P/E of 18.3x is higher than its industry peers (17.2x), it means that investors are paying more than they should for each dollar of IGL's earnings. Therefore, according to this analysis, IGL is an over-priced stock.

Assumptions to be aware of

However, before you rush out to sell your IGL shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to IGL. 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 IGL, 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 IGL to are fairly valued by the market. If this does not hold, there is a possibility that IGL’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 overvaluation could signal a potential selling opportunity to reduce your exposure to IGL. 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.

Are you a potential investor? If IGL 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.