In This Article:
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.
FNM SpA (BIT:FNM) trades with a trailing P/E of 7.3x, which is lower than the industry average of 12.8x. 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 FNM
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 dollar of the company’s earnings.
P/E Calculation for FNM
Price-Earnings Ratio = Price per share ÷ Earnings per share
FNM Price-Earnings Ratio = €0.58 ÷ €0.0805 = 7.3x
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 FNM, 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 7.3, FNM’s P/E is lower than its industry peers (12.8). This implies that investors are undervaluing each dollar of FNM’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 . One could put it like this: the market is pricing FNM as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to FNM, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with FNM, 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 FNM to are fairly valued by the market. If this is violated, FNM’s P/E may be lower than its peers as they are actually overvalued by investors.