This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Redrow plc (LON:RDW) trades with a trailing P/E of 5.9x, which is lower than the industry average of 10.5x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. 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 Redrow
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 RDW
Price-Earnings Ratio = Price per share ÷ Earnings per share
RDW Price-Earnings Ratio = £5.06 ÷ £0.853 = 5.9x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to RDW, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. RDW’s P/E of 5.9 is lower than its industry peers (10.5), which implies that each dollar of RDW’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 23 Consumer Durables companies in GB including Crest Nicholson Holdings, Walker Greenbank and Berkeley Group Holdings. One could put it like this: the market is pricing RDW as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
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 RDW, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with RDW, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing RDW to are fairly valued by the market. If this does not hold true, RDW’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 RDW, 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: