Koda Ltd (SGX:BJZ) is currently trading at a trailing P/E of 11.1x, which is lower than the industry average of 18.2x. While this makes BJZ appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Koda

Breaking down the Price-Earnings ratio

The P/E ratio is one of many ratios used in 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 BJZ

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

BJZ Price-Earnings Ratio = $0.61 ÷ $0.054 = 11.1x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as BJZ, 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. Since BJZ’s P/E of 11.1x is lower than its industry peers (18.2x), it means that investors are paying less than they should for each dollar of BJZ’s earnings. As such, our analysis shows that BJZ represents an under-priced stock.

Assumptions to watch out for

However, before you rush out to buy BJZ, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to BJZ. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with BJZ, 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 BJZ to are fairly valued by the market. If this does not hold true, BJZ’s lower P/E ratio may be because firms in our peer group are 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.