Australian Agricultural Projects Ltd (ASX:AAP) is currently trading at a trailing P/E of 9x, which is lower than the industry average of 11.3x. 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 explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Australian Agricultural Projects
What you need to know about the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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.
P/E Calculation for AAP
Price-Earnings Ratio = Price per share ÷ Earnings per share
AAP Price-Earnings Ratio = 0.03 ÷ 0.003 = 9x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AAP, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 9x, AAP’s P/E is lower than its industry peers (11.3x). This implies that investors are undervaluing each dollar of AAP’s earnings. Therefore, according to this analysis, AAP is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy AAP, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to AAP, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with AAP, 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 AAP to are fairly valued by the market. If this does not hold true, AAP’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 AAP 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 AAP, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.