ALSO Holding AG (SWX:ALSN) is currently trading at a trailing P/E of 14.5x, which is lower than the industry average of 25x. While this makes ALSN appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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. See our latest analysis for ALSO Holding
Demystifying the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 ALSN
Price-Earnings Ratio = Price per share ÷ Earnings per share
ALSN Price-Earnings Ratio = €104.77 ÷ €7.225 = 14.5x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as ALSN, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since ALSN’s P/E of 14.5x is lower than its industry peers (25x), it means that investors are paying less than they should for each dollar of ALSN’s earnings. As such, our analysis shows that ALSN represents an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that ALSN 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 ALSN, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with ALSN, 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 ALSN to are fairly valued by the market. If this is violated, ALSN’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on ALSN, 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. 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 urge you to complete your research by taking a look at the following: