Altaba Inc (NASDAQ:AABA) is currently trading at a trailing P/E of 34.8x, which is lower than the industry average of 39.7x. Although some investors may jump to the conclusion that this is a great buying opportunity, 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. Check out our latest analysis for Altaba
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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for AABA
Price per share = 66.08
Earnings per share = 1.898
∴ Price-Earnings Ratio = 66.08 ÷ 1.898 = 34.8x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to AABA, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
Since AABA's P/E of 34.8x is lower than its industry peers (39.7x), it means that investors are paying less than they should for each dollar of AABA's earnings. Therefore, according to this analysis, AABA is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that AABA represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to AABA. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with AABA, then investors would naturally value AABA at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with AABA, investors would also value AABA at a lower price since it is a lower growth investment. Both scenarios would explain why AABA has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing AABA to are fairly valued by the market. If this assumption is violated, AABA's P/E may be lower than its peers because its peers are actually overvalued by investors.
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 AABA. 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 AABA, 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.
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 Altaba 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.