Axsesstoday Limited (ASX:AXL) is trading with a trailing P/E of 15x, which is lower than the industry average of 14.7x. While this makes AXL 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. See our latest analysis for AXL

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. 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.

Formula

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

P/E Calculation for AXL

Price per share = 1.58

Earnings per share = 0.105

∴ Price-Earnings Ratio = 1.58 ÷ 0.105 = 15x

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 AXL, 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 it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.

AXL’s P/E of 15x is higher than its industry peers (14.7x), which implies that each dollar of AXL’s earnings is being expensive by investors. As such, our analysis shows that AXL represents an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to buy AXL immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to AXL. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing lower risk firms with AXL, then AXL’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with AXL. In this case, AXL’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing AXL to are fairly valued by the market. If this assumption is violated, AXL's P/E may be lower than its peers because its peers are actually overvalued by investors.