Argan Inc (NYSE:AGX) trades with a trailing P/E of 11.9x, which is lower than the industry average of 21.8x. 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 explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Argan
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for 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 AGX
Price-Earnings Ratio = Price per share ÷ Earnings per share
AGX Price-Earnings Ratio = 66.95 ÷ 5.61 = 11.9x
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 AGX, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since AGX's P/E of 11.9x is lower than its industry peers (21.8x), it means that investors are paying less than they should for each dollar of AGX's earnings. As such, our analysis shows that AGX represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy AGX, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to AGX. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with AGX, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing AGX to are fairly valued by the market. If this does not hold true, AGX’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 AGX, 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 you are considering investing in AGX, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
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 Argan 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.