Aurelia Metals Limited (ASX:AMI) is currently trading at a trailing P/E of 4.6x, which is lower than the industry average of 13.5x. While this makes AMI appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, 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 Aurelia Metals

Breaking down the Price-Earnings 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 AMI

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

AMI Price-Earnings Ratio = A$0.36 ÷ A$0.077 = 4.6x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AMI, 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. At 4.6x, AMI’s P/E is lower than its industry peers (13.5x). This implies that investors are undervaluing each dollar of AMI’s earnings. As such, our analysis shows that AMI represents an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy AMI, 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 AMI, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with AMI, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing AMI to are fairly valued by the market. If this does not hold true, AMI’s lower P/E ratio may be because firms in our peer group are 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.