I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Moreton Resources Limited (ASX:MRV) is currently trading at a trailing P/E of 2.4x, which is lower than the industry average of 20.5x. While MRV might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 Moreton Resources
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 MRV
Price-Earnings Ratio = Price per share ÷ Earnings per share
MRV Price-Earnings Ratio = A$0.0090 ÷ A$0.00380 = 2.4x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as MRV, 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. Since MRV’s P/E of 2.4 is lower than its industry peers (20.5), it means that investors are paying less for each dollar of MRV’s earnings. This multiple is a median of profitable companies of 24 Oil and Gas companies in AU including Paladin Energy, Eon NRG and NGE Capital. You can think of it like this: the market is suggesting that MRV is a weaker business than the average comparable company.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. Firstly, our peer group contains companies that are similar to MRV. 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 MRV, 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 MRV to are fairly valued by the market. If this does not hold true, MRV’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 MRV, 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 urge you to complete your research by taking a look at the following: