This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Beghelli SpA (BIT:BE) is trading with a trailing P/E of 17.1x, 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 explain what the P/E ratio is as well as what you should look out for when using it.
See our latest analysis for Beghelli
What you need to know about the P/E 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 BE
Price-Earnings Ratio = Price per share ÷ Earnings per share
BE Price-Earnings Ratio = €0.30 ÷ €0.0176 = 17.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to BE, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 17.1, BE’s P/E is lower than its industry peers (19.4). This implies that investors are undervaluing each dollar of BE’s earnings. Since the Electrical sector in IT is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as IRCE, Cembre and Prysmian. One could put it like this: the market is pricing BE as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to BE. 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 BE, 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 BE to are fairly valued by the market. If this does not hold, there is a possibility that BE’s P/E is lower because our peer group is overvalued by the market.