Mainfreight Limited (NZSE:MFT) is currently trading at a trailing P/E of 24.7x, which is lower than the industry average of 26.3x. While MFT 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for MFT

Breaking down the Price-Earnings ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 MFT

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

MFT Price-Earnings Ratio = 24.98 ÷ 1.011 = 24.7x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 MFT, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 24.7x, MFT’s P/E is lower than its industry peers (26.3x). This implies that investors are undervaluing each dollar of MFT’s earnings. Therefore, according to this analysis, MFT is an under-priced stock.

A few caveats

While our conclusion might prompt you to buy MFT immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to MFT. 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 MFT, 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 MFT to are fairly valued by the market. If this does not hold, there is a possibility that MFT’s P/E is lower because our peer group is overpriced 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 MFT 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.

Are you a potential investor? If you are considering investing in MFT, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Mainfreight for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

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.