Alterra Limited (ASX:1AG) is trading with a trailing P/E of 10.9x, which is lower than the industry average of 21x. 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Alterra
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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.
P/E Calculation for 1AG
Price-Earnings Ratio = Price per share ÷ Earnings per share
1AG Price-Earnings Ratio = 0.04 ÷ 0.003 = 10.9x
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 1AG, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. 1AG’s P/E of 10.9x is lower than its industry peers (21x), which implies that each dollar of 1AG’s earnings is being undervalued by investors. Therefore, according to this analysis, 1AG is an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that 1AG is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to 1AG. 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 1AG, 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 1AG to are fairly valued by the market. If this does not hold true, 1AG’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on 1AG, the undervaluation of the stock may mean it is a good time to top up on 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 1AG 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.