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Orchard Funding Group PLC (AIM:ORCH) is trading with a trailing P/E of 14.2x, which is higher than the industry average of 13.4x. While ORCH might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Orchard Funding Group
Breaking down 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 pound of the company’s earnings.
P/E Calculation for ORCH
Price-Earnings Ratio = Price per share ÷ Earnings per share
ORCH Price-Earnings Ratio = £1 ÷ £0.07 = 14.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 ORCH, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. ORCH’s P/E of 14.2x is higher than its industry peers (13.4x), which implies that each dollar of ORCH’s earnings is being overvalued by investors. Therefore, according to this analysis, ORCH is an over-priced stock.
A few caveats
However, before you rush out to sell your ORCH shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to ORCH. 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 ORCH, 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 ORCH to are fairly valued by the market. If this is violated, ORCH’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on ORCH, the overvaluation of the stock may mean it is a good time to reduce 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following: