Probiotec Limited (ASX:PBP) is currently trading at a trailing P/E of 18.5x, which is lower than the industry average of 24.5x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Probiotec
What you need to know about 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 PBP
Price-Earnings Ratio = Price per share ÷ Earnings per share
PBP Price-Earnings Ratio = A$1 ÷ A$0.054 = 18.5x
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 PBP, 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. At 18.5x, PBP’s P/E is lower than its industry peers (24.5x). This implies that investors are undervaluing each dollar of PBP’s earnings. As such, our analysis shows that PBP represents an under-priced stock.
A few caveats
However, before you rush out to buy PBP, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to PBP, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with PBP, 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 PBP to are fairly valued by the market. If this does not hold, there is a possibility that PBP’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
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 PBP. 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following: