First Real Estate Investment Trust (SGX:AW9U) is trading with a trailing P/E of 15.5x, which is higher than the industry average of 15x. While this makes AW9U appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for First Real Estate Investment Trust

Demystifying the P/E ratio

P/E is a popular ratio used for relative valuation. 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 AW9U

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

AW9U Price-Earnings Ratio = SGD1.4 ÷ SGD0.09 = 15.5x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AW9U, 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. Since AW9U’s P/E of 15.5x is higher than its industry peers (15x), it means that investors are paying more than they should for each dollar of AW9U’s earnings. As such, our analysis shows that AW9U represents an over-priced stock.

A few caveats

However, before you rush out to sell your AW9U shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to AW9U. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with AW9U, 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 AW9U to are fairly valued by the market. If this does not hold true, AW9U’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.