Should You Buy Avocet Mining plc (LSE:AVM) At This PE Ratio?
Avocet Mining plc (LSE:AVM) is currently trading at a trailing P/E of 2x, which is lower than the industry average of 19.9x. While AVM 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. View our latest analysis for Avocet Mining
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 pound of the company’s earnings.
Formula
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for AVM
Price per share = 0.26
Earnings per share = 0.173
∴ Price-Earnings Ratio = 0.26 ÷ 0.173 = 2x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to AVM, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
At 2x, AVM’s P/E is lower than its industry peers (19.9x). This implies that investors are undervaluing each dollar of AVM’s earnings. Therefore, according to this analysis, AVM is an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that AVM 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 AVM. 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 AVM, then investors would naturally value AVM at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with AVM, investors would also value AVM at a lower price since it is a lower growth investment. Both scenarios would explain why AVM has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing AVM to are fairly valued by the market. If this does not hold, there is a possibility that AVM’s P/E is lower because firms in our peer group are being 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 AVM 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 AVM 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 Avocet Mining 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.
