Fortescue Metals Group Limited (ASX:FMG) is currently trading at a trailing P/E of 7.1x, which is lower than the industry average of 13.5x. While FMG might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 Fortescue Metals Group

Demystifying the P/E ratio

P/E is a popular ratio used for 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 FMG

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

FMG Price-Earnings Ratio = $3.56 ÷ $0.499 = 7.1x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to FMG, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since FMG’s P/E of 7.1x is lower than its industry peers (13.5x), it means that investors are paying less than they should for each dollar of FMG’s earnings. As such, our analysis shows that FMG represents an under-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that FMG is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to FMG, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with FMG, 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 FMG to are fairly valued by the market. If this is violated, FMG’s P/E may be lower than its peers as they are actually overvalued by investors.

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.