RXP Services Limited (ASX:RXP) trades with a trailing P/E of 10.3x, which is lower than the industry average of 23.3x. While RXP 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 explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for RXP Services
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 RXP
Price-Earnings Ratio = Price per share ÷ Earnings per share
RXP Price-Earnings Ratio = 0.86 ÷ 0.083 = 10.3x
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 RXP, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 10.3x, RXP’s P/E is lower than its industry peers (23.3x). This implies that investors are undervaluing each dollar of RXP’s earnings. As such, our analysis shows that RXP represents an under-priced stock.
A few caveats
Before you jump to the conclusion that RXP is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to RXP. 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 RXP, 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 RXP to are fairly valued by the market. If this does not hold true, RXP’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? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of RXP to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in RXP, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.