Vita Group Limited (ASX:VTG) is trading with a trailing P/E of 6.4x, which is lower than the industry average of 14.6x. While this makes VTG 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Vita Group
Breaking down the Price-Earnings ratio
The P/E ratio is one of many ratios used in 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 VTG
Price-Earnings Ratio = Price per share ÷ Earnings per share
VTG Price-Earnings Ratio = 1.64 ÷ 0.256 = 6.4x
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 VTG, 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. VTG’s P/E of 6.4x is lower than its industry peers (14.6x), which implies that each dollar of VTG’s earnings is being undervalued by investors. As such, our analysis shows that VTG represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy VTG, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to VTG. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with VTG, 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 VTG to are fairly valued by the market. If this does not hold, there is a possibility that VTG’s P/E is lower because our peer group is overvalued by the market.
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 VTG. 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 VTG, 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.