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Folkestone Limited (ASX:FLK) is trading with a trailing P/E of 12.3x, which is higher than the industry average of 11.4x. While FLK might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 Folkestone
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 FLK
Price-Earnings Ratio = Price per share ÷ Earnings per share
FLK Price-Earnings Ratio = A$1.12 ÷ A$0.091 = 12.3x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as FLK, 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. FLK’s P/E of 12.3x is higher than its industry peers (11.4x), which implies that each dollar of FLK’s earnings is being overvalued by investors. Therefore, according to this analysis, FLK is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that FLK should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to FLK, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with FLK, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing FLK to are fairly valued by the market. If this does not hold, there is a possibility that FLK’s P/E is lower because our peer group is expensive 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.