Alkane Resources Limited (ASX:ALK) trades with a trailing P/E of 13x, which is higher than the industry average of 12.9x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, 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 Alkane Resources

Demystifying the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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 ALK

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

ALK Price-Earnings Ratio = A$0.32 ÷ A$0.024 = 13x

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 ALK, 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. ALK’s P/E of 13x is higher than its industry peers (12.9x), which implies that each dollar of ALK’s earnings is being overvalued by investors. As such, our analysis shows that ALK represents an over-priced stock.

A few caveats

Before you jump to the conclusion that ALK should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to ALK. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with ALK, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing ALK to are fairly valued by the market. If this does not hold, there is a possibility that ALK’s P/E is lower because our peer group is overvalued by the market.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.