Zeta Resources Limited (ASX:ZER) is currently trading at a trailing P/E of 2.5x, which is lower than the industry average of 13.8x. 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 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 Zeta Resources

Demystifying the P/E ratio

The P/E ratio is one of many ratios used in relative valuation. 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 ZER

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

ZER Price-Earnings Ratio = $0.25 ÷ $0.103 = 2.5x

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 ZER, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. ZER’s P/E of 2.5x is lower than its industry peers (13.8x), which implies that each dollar of ZER’s earnings is being undervalued by investors. Therefore, according to this analysis, ZER is an under-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to buy ZER immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to ZER. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with ZER, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing ZER to are fairly valued by the market. If this is violated, ZER’s P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on ZER, 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.

Are you a potential investor? If you are considering investing in ZER, 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.