8I Holdings Limited (ASX:8IH) trades with a trailing P/E of 13.5x, which is lower than the industry average of 19.4x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for 8IH

Breaking down the P/E ratio

The P/E ratio is one of many ratios used in 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 8IH

Price per share = 0.4

Earnings per share = 0.031

∴ Price-Earnings Ratio = 0.4 ÷ 0.031 = 13.5x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 8IH, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. 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.

8IH’s P/E of 13.5x is lower than its industry peers (19.4x), which implies that each dollar of 8IH’s earnings is being undervalued by investors. As such, our analysis shows that 8IH represents an under-priced stock.

A few caveats

Before you jump to the conclusion that 8IH represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to 8IH. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with 8IH, then investors would naturally value 8IH at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with 8IH, investors would also value 8IH at a lower price since it is a lower growth investment. Both scenarios would explain why 8IH has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing 8IH to are fairly valued by the market. If this assumption does not hold true, 8IH’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.