Australian Rural Capital Limited (ASX:ARC) trades with a trailing P/E of 8.1x, which is lower than the industry average of 20.3x. While this makes ARC 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 explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Australian Rural Capital

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. 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 ARC

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

ARC Price-Earnings Ratio = A$0.65 ÷ A$0.08 = 8.1x

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 ARC, 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. Since ARC’s P/E of 8.1x is lower than its industry peers (20.3x), it means that investors are paying less than they should for each dollar of ARC’s earnings. As such, our analysis shows that ARC represents an under-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that ARC is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to ARC. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with ARC, 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 ARC to are fairly valued by the market. If this does not hold, there is a possibility that ARC’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.