Engenco Limited (ASX:EGN) trades with a trailing P/E of 11.3x, which is lower than the industry average of 14.7x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for EGN
What you need to know about 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 EGN
Price-Earnings Ratio = Price per share ÷ Earnings per share
EGN Price-Earnings Ratio = 0.31 ÷ 0.027 = 11.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to EGN, 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. At 11.3x, EGN’s P/E is lower than its industry peers (14.7x). This implies that investors are undervaluing each dollar of EGN’s earnings. As such, our analysis shows that EGN represents an under-priced stock.
A few caveats
Before you jump to the conclusion that EGN 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 EGN, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with EGN, 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 EGN to are fairly valued by the market. If this does not hold true, EGN’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? Since you may have already conducted your due diligence on EGN, 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.
Are you a potential investor? If EGN has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.