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Pro-Pac Packaging Limited (ASX:PPG) is currently trading at a trailing P/E of 19.5x, which is higher than the industry average of 19.4x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Pro-Pac Packaging
What you need to know about the P/E 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 PPG
Price-Earnings Ratio = Price per share ÷ Earnings per share
PPG Price-Earnings Ratio = A$0.41 ÷ A$0.021 = 19.5x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 PPG, 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 PPG’s P/E of 19.5x is higher than its industry peers (19.4x), it means that investors are paying more than they should for each dollar of PPG’s earnings. Therefore, according to this analysis, PPG is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your PPG shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to PPG. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with PPG, 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 PPG to are fairly valued by the market. If this does not hold true, PPG’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.