I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Empired Limited (ASX:EPD) is trading with a trailing P/E of 15.7x, which is lower than the industry average of 24.8x. 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 explain what the P/E ratio is as well as what you should look out for when using it.
Check out our latest analysis for Empired
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 EPD
Price-Earnings Ratio = Price per share ÷ Earnings per share
EPD Price-Earnings Ratio = A$0.48 ÷ A$0.0306 = 15.7x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to EPD, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 15.7, EPD’s P/E is lower than its industry peers (24.8). This implies that investors are undervaluing each dollar of EPD’s earnings. This multiple is a median of profitable companies of 16 IT companies in AU including Cirrus Networks Holdings, CPT Global and RXP Services. You can think of it like this: the market is suggesting that EPD is a weaker business than the average comparable company.
A few caveats
However, 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 EPD, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with EPD, 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 EPD to are fairly valued by the market. If this does not hold true, EPD’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
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 EPD. 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following: