Memtech International Ltd (SGX:BOL) is currently trading at a trailing P/E of 8.3x, which is lower than the industry average of 10.6x. While this makes BOL 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Memtech International
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 BOL
Price-Earnings Ratio = Price per share ÷ Earnings per share
BOL Price-Earnings Ratio = $0.85 ÷ $0.102 = 8.3x
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 BOL, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. BOL’s P/E of 8.3x is lower than its industry peers (10.6x), which implies that each dollar of BOL’s earnings is being undervalued by investors. As such, our analysis shows that BOL represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy BOL immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to BOL, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with BOL, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing BOL to are fairly valued by the market. If this is violated, BOL’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? Since you may have already conducted your due diligence on BOL, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above.
Are you a potential investor? If you are considering investing in BOL, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.