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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.
Vodafone Group Plc (LON:VOD) is trading with a trailing P/E of 12.4x, which is lower than the industry average of 14.3x. While VOD 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
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Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 VOD
Price-Earnings Ratio = Price per share ÷ Earnings per share
VOD Price-Earnings Ratio = €1.96 ÷ €0.159 = 12.4x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to VOD, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since VOD’s P/E of 12.4x is lower than its industry peers (14.3x), it means that investors are paying less than they should for each dollar of VOD’s earnings. Since the sector in is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as , and . Therefore, according to this analysis, VOD is an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that VOD is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to VOD. 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 VOD, 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 VOD to are fairly valued by the market. If this does not hold, there is a possibility that VOD’s P/E is lower because our peer group is overvalued by the market.