Pental Limited (ASX:PTL) trades with a trailing P/E of 15x, which is lower than the industry average of 23.9x. While this makes PTL 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 break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Pental
Breaking down the Price-Earnings 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 PTL
Price-Earnings Ratio = Price per share ÷ Earnings per share
PTL Price-Earnings Ratio = 0.65 ÷ 0.043 = 15x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to PTL, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. PTL’s P/E of 15x is lower than its industry peers (23.9x), which implies that each dollar of PTL’s earnings is being undervalued by investors. Therefore, according to this analysis, PTL is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy PTL, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to PTL. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with PTL, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing PTL to are fairly valued by the market. If this is violated, PTL's P/E may be lower than its peers as they are actually expensive by investors.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to PTL. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.
Are you a potential investor? If you are considering investing in PTL, 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.