Villa World Limited (ASX:VLW) trades with a trailing P/E of 7.5x, which is lower than the industry average of 11.6x. 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. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for VLW
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 VLW
Price-Earnings Ratio = Price per share ÷ Earnings per share
VLW Price-Earnings Ratio = 2.44 ÷ 0.325 = 7.5x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as VLW, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since VLW's P/E of 7.5x is lower than its industry peers (11.6x), it means that investors are paying less than they should for each dollar of VLW's earnings. As such, our analysis shows that VLW represents an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy VLW immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to VLW. 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 VLW, 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 VLW to are fairly valued by the market. If this is violated, VLW's P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to VLW. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.
Are you a potential investor? If VLW has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.