Draper Esprit plc (AIM:GROW) is trading with a trailing P/E of 4x, which is lower than the industry average of 21.9x. While this makes GROW appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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. View our latest analysis for Draper Esprit

Breaking down the P/E 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 pound of the company’s earnings.

Formula

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

P/E Calculation for GROW

Price per share = 3.23

Earnings per share = 0.808

∴ Price-Earnings Ratio = 3.23 ÷ 0.808 = 4x

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 GROW, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.

Since GROW's P/E of 4x is lower than its industry peers (21.9x), it means that investors are paying less than they should for each dollar of GROW's earnings. As such, our analysis shows that GROW represents an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy GROW, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to GROW. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with GROW, then investors would naturally value GROW at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with GROW, investors would also value GROW at a lower price since it is a lower growth investment. Both scenarios would explain why GROW has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing GROW to are fairly valued by the market. If this assumption is violated, GROW's P/E may be lower than its peers because its peers are actually overvalued by investors.