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 begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Lian Beng Group Ltd (SGX:L03) trades with a trailing P/E of 4.9x, which is lower than the industry average of 10x. While L03 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 explain what the P/E ratio is as well as what you should look out for when using it.
View our latest analysis for Lian Beng Group
What you need to know about the P/E ratio
A common ratio used for relative valuation is the P/E ratio. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for L03
Price-Earnings Ratio = Price per share ÷ Earnings per share
L03 Price-Earnings Ratio = SGD0.53 ÷ SGD0.109 = 4.9x
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 L03, 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. L03’s P/E of 4.9 is lower than its industry peers (10), which implies that each dollar of L03’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 23 Construction companies in SG including Keong Hong Holdings, AusGroup and Sapphire. You can think of it like this: the market is suggesting that L03 is a weaker business than the average comparable company.
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 L03. 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 L03, 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 L03 to are fairly valued by the market. If this does not hold, there is a possibility that L03’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on L03, 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 highly recommend you to complete your research by taking a look at the following: