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This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.
Arkema SA (EPA:AKE) is currently trading at a trailing P/E of 12.5x, which is lower than the industry average of 16.6x. 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
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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 AKE
Price-Earnings Ratio = Price per share ÷ Earnings per share
AKE Price-Earnings Ratio = €107.9 ÷ €8.605 = 12.5x
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 AKE, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. AKE’s P/E of 12.5 is lower than its industry peers (16.6), which implies that each dollar of AKE’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 7 Chemicals companies in FR including Plastiques du Val de Loire, EPC Groupe and Société Internationale de Plantations d’Hévéas Société Anonyme. You can think of it like this: the market is suggesting that AKE is a weaker business than the average comparable company.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to AKE. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with AKE, 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 AKE to are fairly valued by the market. If this is violated, AKE’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of AKE to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 highly recommend you to complete your research by taking a look at the following: