I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.

Laserbond Limited (ASX:LBL) is currently trading at a trailing P/E of 19, which is higher than the industry average of 14.4. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Laserbond

What you need to know about 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 LBL

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

LBL Price-Earnings Ratio = A$0.20 ÷ A$0.0105 = 19x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to LBL, 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. LBL’s P/E of 19 is higher than its industry peers (14.4), which implies that each dollar of LBL’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 7 Machinery companies in AU including Oldfields Holdings, Environmental Group and MaxiTRANS Industries. You could think of it like this: the market is pricing LBL as if it is a stronger company than the average of its industry group.

Assumptions to be aware of

However, it is important to note that our examination of the stock is based on certain assumptions. Firstly, that our peer group contains companies that are similar to LBL. If this isn’t the case, the difference in P/E could be due to other factors. For example, if Laserbond Limited is growing faster than its peers, then it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to LBL may not be fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.

What this means for you:

If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in LBL. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 highly recommend you to complete your research by taking a look at the following: