Design Studio Group Ltd (SGX:D11) is currently trading at a trailing P/E of 10.1x, which is lower than the industry average of 25x. While D11 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. Today, 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 Design Studio Group

Breaking down the Price-Earnings ratio

The P/E ratio is one of many ratios used in relative valuation. 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 D11

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

D11 Price-Earnings Ratio = SGD0.56 ÷ SGD0.055 = 10.1x

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 D11, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since D11’s P/E of 10.1x is lower than its industry peers (25x), it means that investors are paying less than they should for each dollar of D11’s earnings. Therefore, according to this analysis, D11 is an under-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to buy D11 immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to D11, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with D11, 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 D11 to are fairly valued by the market. If this does not hold true, D11’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

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 D11. 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.