DWS Limited (ASX:DWS) is currently trading at a trailing P/E of 10.2x, which is lower than the industry average of 23.3x. While DWS 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. See our latest analysis for DWS

Breaking down the P/E ratio

A common ratio used for relative valuation is the P/E ratio. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for DWS

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

DWS Price-Earnings Ratio = 1.35 ÷ 0.132 = 10.2x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 DWS, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 10.2x, DWS’s P/E is lower than its industry peers (23.3x). This implies that investors are undervaluing each dollar of DWS’s earnings. As such, our analysis shows that DWS represents an under-priced stock.

A few caveats

However, before you rush out to buy DWS, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to DWS, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with DWS, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing DWS to are fairly valued by the market. If this does not hold, there is a possibility that DWS’s P/E is lower because our peer group is overvalued 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 DWS 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 DWS, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.