Retail Food Group Limited (ASX:RFG) is currently trading at a trailing P/E of 12.2x, which is lower than the industry average of 21.2x. While this makes RFG appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Retail Food Group
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.
P/E Calculation for RFG
Price-Earnings Ratio = Price per share ÷ Earnings per share
RFG Price-Earnings Ratio = 4.36 ÷ 0.357 = 12.2x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to RFG, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. RFG’s P/E of 12.2x is lower than its industry peers (21.2x), which implies that each dollar of RFG’s earnings is being undervalued by investors. Therefore, according to this analysis, RFG is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy RFG immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to RFG. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with RFG, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing RFG to are fairly valued by the market. If this is violated, RFG'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? 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 RFG. 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.