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.

Schaffer Corporation Limited (ASX:SFC) is trading with a trailing P/E of 11.7x, which is lower than the industry average of 15.5x. While this makes SFC 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.

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Breaking down the P/E 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 SFC

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

SFC Price-Earnings Ratio = A$15.95 ÷ A$1.363 = 11.7x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SFC, 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 11.7, SFC’s P/E is lower than its industry peers (15.5). This implies that investors are undervaluing each dollar of SFC’s earnings. This multiple is a median of profitable companies of stocks internationally, operating in the Auto Components industry. I’ve decided to use a global peer group as there’s not enough companies in AU that are considered as appropriate peers, and I wanted to get a broader perspective on the regional multiple. Some peers include GUD Holdings, PWR Holdings and ARB. You can think of it like this: the market is suggesting that SFC is a weaker business than the average comparable company.

A few caveats

However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to SFC. 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 SFC, 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 SFC to are fairly valued by the market. If this is violated, SFC’s P/E may be lower than its peers as they are actually overvalued by investors.