Horizon Gold Limited (ASX:HRN) trades with a trailing P/E of 1.4x, which is lower than the industry average of 13.1x. While HRN 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. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Horizon Gold
What you need to know about 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 HRN
Price-Earnings Ratio = Price per share ÷ Earnings per share
HRN Price-Earnings Ratio = 0.28 ÷ 0.206 = 1.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to HRN, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 1.4x, HRN’s P/E is lower than its industry peers (13.1x). This implies that investors are undervaluing each dollar of HRN’s earnings. As such, our analysis shows that HRN represents an under-priced stock.
A few caveats
However, before you rush out to buy HRN, 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 HRN, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with HRN, 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 HRN to are fairly valued by the market. If this is violated, HRN's P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to HRN. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.
Are you a potential investor? If you are considering investing in HRN, 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.