St Barbara Limited (ASX:SBM) is trading with a trailing P/E of 9.2x, which is lower than the industry average of 19.3x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for SBM
Breaking down the Price-Earnings 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.
Formula
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for SBM
Price per share = 2.91
Earnings per share = 0.317
∴ Price-Earnings Ratio = 2.91 ÷ 0.317 = 9.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SBM, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
SBM’s P/E of 9.2x is lower than its industry peers (19.3x), which implies that each dollar of SBM’s earnings is being undervalued by investors. Therefore, according to this analysis, SBM is an under-priced stock.
A few caveats
However, before you rush out to buy SBM, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to SBM. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing lower risk firms with SBM, then SBM’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with SBM. In this case, SBM’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing SBM to are fairly valued by the market. If this does not hold, there is a possibility that SBM’s P/E is lower because firms in our peer group are being overvalued by the market.