RCG Corporation Limited (ASX:RCG) trades with a trailing P/E of 13.5x, which is lower than the industry average of 14.6x. While RCG might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for RCG

Breaking down the Price-Earnings ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 RCG

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

RCG Price-Earnings Ratio = 0.75 ÷ 0.055 = 13.5x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to RCG, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. RCG’s P/E of 13.5x is lower than its industry peers (14.6x), which implies that each dollar of RCG’s earnings is being undervalued by investors. Therefore, according to this analysis, RCG is an under-priced stock.

A few caveats

While our conclusion might prompt you to buy RCG immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to RCG. 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 RCG, 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 RCG to are fairly valued by the market. If this does not hold true, RCG’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of RCG to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.

Are you a potential investor? If RCG has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on RCG for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

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.