Aveo Group (ASX:AOG) is currently trading at a trailing P/E of 5.2x, which is lower than the industry average of 11.5x. While AOG 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. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Aveo Group

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 AOG

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

AOG Price-Earnings Ratio = 2.3 ÷ 0.442 = 5.2x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AOG, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 5.2x, AOG’s P/E is lower than its industry peers (11.5x). This implies that investors are undervaluing each dollar of AOG’s earnings. Therefore, according to this analysis, AOG is an under-priced stock.

A few caveats

Before you jump to the conclusion that AOG is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to AOG, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with AOG, 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 AOG to are fairly valued by the market. If this is violated, AOG's P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

Are you a shareholder? 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 AOG 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.

Are you a potential investor? If you are considering investing in AOG, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.