Infomedia Ltd (ASX:IFM) is currently trading at a trailing P/E of 20.4x, which is lower than the industry average of 33.2x. 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 IFM

Demystifying the P/E ratio

The P/E ratio is one of many ratios used in relative valuation. 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 IFM

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

IFM Price-Earnings Ratio = 0.79 ÷ 0.039 = 20.4x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to IFM, 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. IFM’s P/E of 20.4x is lower than its industry peers (33.2x), which implies that each dollar of IFM’s earnings is being undervalued by investors. As such, our analysis shows that IFM represents an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy IFM, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to IFM. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with IFM, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing IFM to are fairly valued by the market. If this does not hold true, IFM’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? You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to IFM. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.

Are you a potential investor? If you are considering investing in IFM, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.