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West Wits Mining Limited (ASX:WWI) is currently trading at a trailing P/E of 21.1x, which is higher than the industry average of 13.9x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. 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 West Wits Mining
Breaking down the Price-Earnings 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 WWI
Price-Earnings Ratio = Price per share ÷ Earnings per share
WWI Price-Earnings Ratio = A$0.02 ÷ A$0.001 = 21.1x
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 WWI, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 21.1x, WWI’s P/E is higher than its industry peers (13.9x). This implies that investors are overvaluing each dollar of WWI’s earnings. As such, our analysis shows that WWI represents an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your WWI shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to WWI, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with WWI, 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 WWI to are fairly valued by the market. If this is violated, WWI’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 WWI, 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: