The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Ansell Limited (ASX:ANN) trades with a trailing P/E of 18.8x, which is lower than the industry average of 28.8x. While this makes ANN 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 Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 ANN
Price-Earnings Ratio = Price per share ÷ Earnings per share
ANN Price-Earnings Ratio = $18.09 ÷ $0.965 = 18.8x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ANN, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. ANN’s P/E of 18.8 is lower than its industry peers (28.8), which implies that each dollar of ANN’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 6 Medical Equipment companies in AU including SDI, Azure Healthcare and Compumedics. One could put it like this: the market is pricing ANN as if it is a weaker company than the average company in its industry.
A few caveats
However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to ANN. 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 ANN, 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 ANN to are fairly valued by the market. If this is violated, ANN’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 ANN, 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for ANN’s future growth? Take a look at our free research report of analyst consensus for ANN’s outlook.
- Past Track Record: Has ANN 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 ANN’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.