This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.

Peninsula Energy Limited (ASX:PEN) is trading with a trailing P/E of 4.4x, which is lower than the industry average of 20.9x. While PEN 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 Peninsula Energy

What you need to know about the P/E ratio

P/E is a popular ratio used for relative valuation. 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 PEN

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

PEN Price-Earnings Ratio = $0.17 ÷ $0.0398 = 4.4x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to PEN, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 4.4, PEN’s P/E is lower than its industry peers (20.9). This implies that investors are undervaluing each dollar of PEN’s earnings. This multiple is a median of profitable companies of 24 Oil and Gas companies in AU including Paladin Energy, Moreton Resources and Eon NRG. You can think of it like this: the market is suggesting that PEN 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. The first is that our “similar companies” are actually similar to PEN, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with PEN, 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 PEN to are fairly valued by the market. If this does not hold, there is a possibility that PEN’s P/E is lower because our peer group is overvalued by the market.