Acorn International Inc (NYSE:ATV) is currently trading at a trailing P/E of 15.6x, which is lower than the industry average of 25.2x. While ATV 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Acorn International
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in 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 ATV
Price-Earnings Ratio = Price per share ÷ Earnings per share
ATV Price-Earnings Ratio = 14.17 ÷ 0.91 = 15.6x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ATV, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. ATV’s P/E of 15.6x is lower than its industry peers (25.2x), which implies that each dollar of ATV’s earnings is being undervalued by investors. As such, our analysis shows that ATV represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy ATV, 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 ATV, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with ATV, 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 ATV to are fairly valued by the market. If this does not hold true, ATV’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 ATV 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 ATV 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 Acorn International 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.