Shriro Holdings Limited (ASX:SHM) is currently trading at a trailing P/E of 9.2x, which is lower than the industry average of 17.5x. While this makes SHM 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 break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Shriro Holdings

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 SHM

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

SHM Price-Earnings Ratio = 1.29 ÷ 0.141 = 9.2x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as SHM, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. SHM’s P/E of 9.2x is lower than its industry peers (17.5x), which implies that each dollar of SHM’s earnings is being undervalued by investors. As such, our analysis shows that SHM represents an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy SHM, 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 SHM, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with SHM, 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 SHM to are fairly valued by the market. If this does not hold, there is a possibility that SHM’s P/E is lower because our peer group is 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 SHM. 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.