Hotcopper Holdings Limited (ASX:HOT) is currently trading at a trailing P/E of 25.3x, which is lower than the industry average of 29x. 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. See our latest analysis for Hotcopper Holdings

Demystifying the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 HOT

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

HOT Price-Earnings Ratio = A$0.23 ÷ A$0.009 = 25.3x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 HOT, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. HOT’s P/E of 25.3x is lower than its industry peers (29x), which implies that each dollar of HOT’s earnings is being undervalued by investors. Therefore, according to this analysis, HOT is an under-priced stock.

A few caveats

Before you jump to the conclusion that HOT is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to HOT, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with HOT, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing HOT to are fairly valued by the market. If this does not hold true, HOT’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.