Jumbo Interactive Limited (ASX:JIN) is trading with a trailing P/E of 16.3x, which is lower than the industry average of 21.2x. While this makes JIN appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Jumbo Interactive

Breaking down the Price-Earnings ratio

P/E is a popular ratio used for relative valuation. 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 JIN

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

JIN Price-Earnings Ratio = 2.75 ÷ 0.169 = 16.3x

On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as JIN, 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 JIN's P/E of 16.3x is lower than its industry peers (21.2x), it means that investors are paying less than they should for each dollar of JIN's earnings. As such, our analysis shows that JIN represents an under-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to buy JIN immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to JIN, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with JIN, 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 JIN to are fairly valued by the market. If this does not hold true, JIN’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? 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 JIN. 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 JIN 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 Jumbo Interactive 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.