Kabuni Limited (ASX:S3R) is currently trading at a trailing P/E of 1.5x, which is lower than the industry average of 28.5x. While S3R 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Kabuni

Demystifying the P/E ratio

P/E is a popular ratio used for relative valuation. 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 S3R

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

S3R Price-Earnings Ratio = A$0.01 ÷ A$0.006 = 1.5x

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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to S3R, 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 S3R’s P/E of 1.5x is lower than its industry peers (28.5x), it means that investors are paying less than they should for each dollar of S3R’s earnings. Therefore, according to this analysis, S3R is an under-priced stock.

Assumptions to be aware of

However, before you rush out to buy S3R, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to S3R, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with S3R, 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 S3R to are fairly valued by the market. If this does not hold, there is a possibility that S3R’s P/E is lower because our peer group is overvalued by the market.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.