Alliance Data Systems Corporation (NYSE:ADS) is currently trading at a trailing P/E of 24.4x, which is lower than the industry average of 28.5x. While ADS 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. 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. View our latest analysis for Alliance Data Systems
What you need to know about the P/E 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 ADS
Price-Earnings Ratio = Price per share ÷ Earnings per share
ADS Price-Earnings Ratio = 229.61 ÷ 9.395 = 24.4x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 ADS, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 24.4x, ADS’s P/E is lower than its industry peers (28.5x). This implies that investors are undervaluing each dollar of ADS’s earnings. As such, our analysis shows that ADS represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy ADS immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to ADS. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with ADS, 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 ADS to are fairly valued by the market. If this does not hold true, ADS’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? Since you may have already conducted your due diligence on ADS, 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.
Are you a potential investor? If ADS 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 Alliance Data Systems 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.