Pacific Current Group Limited (ASX:PAC) trades with a trailing P/E of 2.8x, which is lower than the industry average of 19.9x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Pacific Current Group

Breaking down the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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 PAC

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

PAC Price-Earnings Ratio = A$6.68 ÷ A$2.345 = 2.8x

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 PAC, 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. Since PAC’s P/E of 2.8x is lower than its industry peers (19.9x), it means that investors are paying less than they should for each dollar of PAC’s earnings. Therefore, according to this analysis, PAC is an under-priced stock.

A few caveats

While our conclusion might prompt you to buy PAC immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to PAC. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with PAC, 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 PAC to are fairly valued by the market. If this does not hold true, PAC’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.