amaysim Australia Limited (ASX:AYS) is trading with a trailing P/E of 32.8x, which is higher than the industry average of 27.3x. 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. 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 AYS
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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.
P/E Calculation for AYS
Price-Earnings Ratio = Price per share ÷ Earnings per share
AYS Price-Earnings Ratio = 2.01 ÷ 0.061 = 32.8x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AYS, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 32.8x, AYS’s P/E is higher than its industry peers (27.3x). This implies that investors are overvaluing each dollar of AYS’s earnings. As such, our analysis shows that AYS represents an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your AYS 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 AYS. 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 AYS, 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 AYS to are fairly valued by the market. If this is violated, AYS's P/E may be lower than its peers as they are actually overpriced by investors.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on AYS, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.
Are you a potential investor? If you are considering investing in AYS, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.