In This Article:
The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about the link between company’s fundamentals and stock market performance.
The Hour Glass Limited (SGX:AGS) trades on a trailing P/E of 8.1. This isn’t too far from the industry average (which is 8.6). While this makes AGS appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
See our latest analysis for Hour Glass
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. 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 AGS
Price-Earnings Ratio = Price per share ÷ Earnings per share
AGS Price-Earnings Ratio = SGD0.66 ÷ SGD0.0810 = 8.1x
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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AGS, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. The Hour Glass Limited (SGX:AGS) trades on a trailing P/E of 8.1. This isn’t too far from the industry average (which is 8.6). This multiple is a median of profitable companies of 5 Specialty Retail companies in SG including Cortina Holdings, Noel Gifts International and Challenger Technologies. One could put it like this: the market is pricing AGS as if it is roughly average for its industry.
Assumptions to watch out for
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to AGS. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with AGS, 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 AGS to are fairly valued by the market. If this is violated, AGS’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on AGS, 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 urge you to complete your research by taking a look at the following: