Bellevue Group AG (SWX:BBN) trades with a trailing P/E of 15.8x, which is lower than the industry average of 20.5x. While this makes BBN appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Bellevue Group

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 BBN

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

BBN Price-Earnings Ratio = CHF25.3 ÷ CHF1.601 = 15.8x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as BBN, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since BBN’s P/E of 15.8x is lower than its industry peers (20.5x), it means that investors are paying less than they should for each dollar of BBN’s earnings. As such, our analysis shows that BBN represents an under-priced stock.

Assumptions to watch out for

However, before you rush out to buy BBN, 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 BBN, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with BBN, 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 BBN to are fairly valued by the market. If this does not hold true, BBN’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.