Image Sensing Systems Inc (NASDAQ:ISNS) is currently trading at a trailing P/E of 24.2x, which is lower than the industry average of 25.8x. 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 Image Sensing Systems
Demystifying 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 ISNS
Price-Earnings Ratio = Price per share ÷ Earnings per share
ISNS Price-Earnings Ratio = $3.35 ÷ $0.138 = 24.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to ISNS, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 24.2x, ISNS’s P/E is lower than its industry peers (25.8x). This implies that investors are undervaluing each dollar of ISNS’s earnings. As such, our analysis shows that ISNS represents an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy ISNS immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to ISNS, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with ISNS, 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 ISNS to are fairly valued by the market. If this is violated, ISNS’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? 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 ISNS. 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.
Are you a potential investor? If you are considering investing in ISNS, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.