This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Abcourt Mines Inc (CVE:ABI) is currently trading at a trailing P/E of 6.6x, which is lower than the industry average of 9.2x. While this makes ABI 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down the P/E 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 ABI
Price-Earnings Ratio = Price per share ÷ Earnings per share
ABI Price-Earnings Ratio = CA$0.055 ÷ CA$0.00832 = 6.6x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to ABI, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since ABI’s P/E of 6.6 is lower than its industry peers (9.2), it means that investors are paying less for each dollar of ABI’s earnings. This multiple is a median of profitable companies of 25 Metals and Mining companies in CA including Winston Resources, European Electric Metals and Sherritt International. One could put it like this: the market is pricing ABI as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
However, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to ABI, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with ABI, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing ABI to are fairly valued by the market. If this does not hold true, ABI’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on ABI, the undervaluation of the stock may mean it is a good time to top up on 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 highly recommend you to complete your research by taking a look at the following:
- Financial Health: Are ABI’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has ABI been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of ABI’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past 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. For errors that warrant correction please contact the editor at firstname.lastname@example.org.