Euroz Limited (ASX:EZL) is currently trading at a trailing P/E of 8.5x, which is lower than the industry average of 21.7x. While EZL 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. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Euroz
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 EZL
Price-Earnings Ratio = Price per share ÷ Earnings per share
EZL Price-Earnings Ratio = 1.04 ÷ 0.123 = 8.5x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to EZL, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since EZL's P/E of 8.5x is lower than its industry peers (21.7x), it means that investors are paying less than they should for each dollar of EZL's earnings. Therefore, according to this analysis, EZL is an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that EZL 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 EZL, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with EZL, 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 EZL to are fairly valued by the market. If this does not hold, there is a possibility that EZL’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of EZL to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.