In This Article:
I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Forterra plc (LON:FORT) trades with a trailing P/E of 10.6x, which is lower than the industry average of 20.4x. 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. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
View our latest analysis for Forterra
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 dollar of the company’s earnings.
P/E Calculation for FORT
Price-Earnings Ratio = Price per share ÷ Earnings per share
FORT Price-Earnings Ratio = £2.57 ÷ £0.242 = 10.6x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as FORT, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since FORT’s P/E of 10.6 is lower than its industry peers (20.4), it means that investors are paying less for each dollar of FORT’s earnings. This multiple is a median of profitable companies of 7 Basic Materials companies in GB including Ibstock, Marshalls and Breedon Group. One could put it like this: the market is pricing FORT as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to FORT. 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 FORT, 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 FORT to are fairly valued by the market. If this does not hold, there is a possibility that FORT’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on FORT, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. 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 highly recommend you to complete your research by taking a look at the following: