Randall & Quilter Investment Holdings Ltd (AIM:RQIH) is currently trading at a trailing P/E of 7.9x, which is lower than the industry average of 15.9x. While this makes RQIH 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Randall & Quilter Investment Holdings
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 pound of the company’s earnings.
P/E Calculation for RQIH
Price-Earnings Ratio = Price per share ÷ Earnings per share
RQIH Price-Earnings Ratio = 1.44 ÷ 0.181 = 7.9x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as RQIH, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. RQIH’s P/E of 7.9x is lower than its industry peers (15.9x), which implies that each dollar of RQIH’s earnings is being undervalued by investors. Therefore, according to this analysis, RQIH is an under-priced stock.
A few caveats
While our conclusion might prompt you to buy RQIH immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to RQIH, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with RQIH, 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 RQIH to are fairly valued by the market. If this does not hold, there is a possibility that RQIH’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of RQIH to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in RQIH, 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.