The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
LandMark White Limited (ASX:LMW) trades with a trailing P/E of 10.7x, which is lower than the industry average of 12.1x. While this makes LMW 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 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 LandMark White
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief 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 LMW
Price-Earnings Ratio = Price per share ÷ Earnings per share
LMW Price-Earnings Ratio = A$0.58 ÷ A$0.0544 = 10.7x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to LMW, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. LMW’s P/E of 10.7 is lower than its industry peers (12.1), which implies that each dollar of LMW’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 23 Real Estate companies in AU including Axiom Properties, Aveo Group and Phileo Australia. One could put it like this: the market is pricing LMW as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to LMW. 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 LMW, 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 LMW to are fairly valued by the market. If this does not hold, there is a possibility that LMW’s P/E is lower because our peer group is overvalued by the market.