Aventus Retail Property Fund (ASX:AVN) is currently trading at a trailing P/E of 5.9x, which is lower than the industry average of 13.8x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Aventus Retail Property Fund

Breaking down the Price-Earnings 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.

Formula

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

P/E Calculation for AVN

Price per share = 2.33

Earnings per share = 0.392

∴ Price-Earnings Ratio = 2.33 ÷ 0.392 = 5.9x

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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AVN, 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.

Since AVN's P/E of 5.9x is lower than its industry peers (13.8x), it means that investors are paying less than they should for each dollar of AVN's earnings. As such, our analysis shows that AVN represents an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy AVN, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to AVN. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with AVN, then AVN’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with AVN, AVN’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing AVN to are fairly valued by the market. If this does not hold, there is a possibility that AVN’s P/E is lower because firms in our peer group are being overvalued by the market.