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K2 Asset Management Holdings Ltd (ASX:KAM) is currently trading at a trailing P/E of 8x, which is lower than the industry average of 18.9x. 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 K2 Asset Management Holdings
Breaking down the Price-Earnings 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 KAM
Price-Earnings Ratio = Price per share ÷ Earnings per share
KAM Price-Earnings Ratio = A$0.2 ÷ A$0.024 = 8x
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 KAM, 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. At 8x, KAM’s P/E is lower than its industry peers (18.9x). This implies that investors are undervaluing each dollar of KAM’s earnings. As such, our analysis shows that KAM represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy KAM immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to KAM, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with KAM, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing KAM to are fairly valued by the market. If this does not hold, there is a possibility that KAM’s P/E is lower because our peer group is 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.