AWF Madison Group Limited (NZSE:AWF) trades with a trailing P/E of 12.3x, which is lower than the industry average of 21.8x. While AWF might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 AWF Madison Group
Breaking down 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 AWF
Price-Earnings Ratio = Price per share ÷ Earnings per share
AWF Price-Earnings Ratio = NZ$1.9 ÷ NZ$0.155 = 12.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to AWF, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since AWF’s P/E of 12.3x is lower than its industry peers (21.8x), it means that investors are paying less than they should for each dollar of AWF’s earnings. As such, our analysis shows that AWF represents an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that AWF is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to AWF, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with AWF, 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 AWF to are fairly valued by the market. If this is violated, AWF’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on AWF, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following: