This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Impellam Group PLC (LON:IPEL) trades with a trailing P/E of 9.6x, which is lower than the industry average of 18.8x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. 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 Impellam Group
Breaking down the Price-Earnings 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 IPEL
Price-Earnings Ratio = Price per share ÷ Earnings per share
IPEL Price-Earnings Ratio = £5.9 ÷ £0.616 = 9.6x
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 IPEL, 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. IPEL’s P/E of 9.6 is lower than its industry peers (18.8), which implies that each dollar of IPEL’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Professional Services companies in GB including Tekcapital, Mind Gym and Servoca. You can think of it like this: the market is suggesting that IPEL is a weaker business than the average comparable company.
A few caveats
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to IPEL. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with IPEL, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing IPEL to are fairly valued by the market. If this does not hold true, IPEL’s lower P/E ratio may be because firms in our peer group are overvalued by the market.