Paragon Care Limited (ASX:PGC) trades with a trailing P/E of 13.6x, which is lower than the industry average of 17.9x. While PGC 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. In this article, 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 PGC
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 PGC
Price-Earnings Ratio = Price per share ÷ Earnings per share
PGC Price-Earnings Ratio = A$0.85 ÷ A$0.062 = 13.6x
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 PGC, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 13.6x, PGC’s P/E is lower than its industry peers (17.9x). This implies that investors are undervaluing each dollar of PGC’s earnings. Therefore, according to this analysis, PGC is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy PGC immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to PGC, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with PGC, 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 PGC to are fairly valued by the market. If this is violated, PGC’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on PGC, 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.
Are you a potential investor? If you are considering investing in PGC, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.