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 start learning about core concepts of fundamental analysis on practical examples from today’s market.
Interra Resources Limited (SGX:5GI) is trading with a trailing P/E of 18.8, which is higher than the industry average of 7.6. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Check out our latest analysis for Interra Resources
Demystifying the P/E 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 5GI
Price-Earnings Ratio = Price per share ÷ Earnings per share
5GI Price-Earnings Ratio = $0.031 ÷ $0.00163 = 18.8x
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 5GI, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 18.8, 5GI’s P/E is higher than its industry peers (7.6). This implies that investors are overvaluing each dollar of 5GI’s earnings. This multiple is a median of profitable companies of 6 Oil and Gas companies in SG including Ouhua Energy Holdings, Sinostar PEC Holdings and Golden Energy and Resources. You could think of it like this: the market is pricing 5GI as if it is a stronger company than the average of its industry group.
Assumptions to be aware of
However, you should be aware that this analysis makes certain assumptions. Firstly, that our peer group contains companies that are similar to 5GI. If this isn’t the case, the difference in P/E could be due to other factors. Take, for example, the scenario where Interra Resources Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. We should also be aware that the stocks we are comparing to 5GI may not be fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.