I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Legend Corporation Limited (ASX:LGD) is trading with a trailing P/E of 12.1x, which is lower than the industry average of 15.4x. While this makes LGD 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
See our latest analysis for Legend
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. 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 LGD
Price-Earnings Ratio = Price per share ÷ Earnings per share
LGD Price-Earnings Ratio = A$0.34 ÷ A$0.0280 = 12.1x
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 LGD, 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 12.1, LGD’s P/E is lower than its industry peers (15.4). This implies that investors are undervaluing each dollar of LGD’s earnings. This multiple is a median of profitable companies of 6 Trade Distributors companies in AU including Acrow Formwork and Construction Services, HGL and Seven Group Holdings. You can think of it like this: the market is suggesting that LGD is a weaker business than the average comparable company.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to LGD, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with LGD, 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 LGD to are fairly valued by the market. If this is violated, LGD’s P/E may be lower than its peers as they are actually overvalued by investors.