Alpha Financial Markets Consulting UK Limited (LSE:AFM) is currently trading at a trailing P/E of 0.1x, which is lower than the industry average of 16.4x. While AFM 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 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 AFM
Demystifying 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 pound of the company’s earnings.
P/E Calculation for AFM
Price-Earnings Ratio = Price per share ÷ Earnings per share
AFM Price-Earnings Ratio = 1.6 ÷ 17.902 = 0.1x
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 AFM, 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. AFM’s P/E of 0.1x is lower than its industry peers (16.4x), which implies that each dollar of AFM’s earnings is being undervalued by investors. Therefore, according to this analysis, AFM is an under-priced stock.
A few caveats
However, before you rush out to buy AFM, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to AFM, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with AFM, 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 AFM to are fairly valued by the market. If this is violated, AFM'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? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of AFM to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If AFM 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.