MCBC Holdings Inc (NASDAQ:MCFT) trades with a trailing P/E of 17.5x, which is lower than the industry average of 26.7x. While this makes MCFT appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for MCBC Holdings

What you need to know about the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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 MCFT

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

MCFT Price-Earnings Ratio = $30.94 ÷ $1.764 = 17.5x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as MCFT, 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. MCFT’s P/E of 17.5x is lower than its industry peers (26.7x), which implies that each dollar of MCFT’s earnings is being undervalued by investors. Therefore, according to this analysis, MCFT is an under-priced stock.

A few caveats

However, before you rush out to buy MCFT, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to MCFT. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with MCFT, 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 MCFT to are fairly valued by the market. If this does not hold true, MCFT’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

Since you may have already conducted your due diligence on MCFT, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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: