When Should You Buy Firestone Diamonds plc (AIM:FDI)?
Firestone Diamonds plc (AIM:FDI) is trading with a trailing P/E of 13.7x, which is lower than the industry average of 13.9x. 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. View our latest analysis for Firestone Diamonds
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 pound of the company’s earnings.
P/E Calculation for FDI
Price-Earnings Ratio = Price per share ÷ Earnings per share
FDI Price-Earnings Ratio = 0.21 ÷ 0.02 = 13.7x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to FDI, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 13.7x, FDI’s P/E is lower than its industry peers (13.9x). This implies that investors are undervaluing each dollar of FDI’s earnings. Therefore, according to this analysis, FDI is an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that FDI is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to FDI, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with FDI, 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 FDI to are fairly valued by the market. If this is violated, FDI’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to FDI. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.
Are you a potential investor? If FDI 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 Firestone Diamonds 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.
