This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Inter-Rock Minerals Inc (CVE:IRO) is currently trading at a trailing P/E of 4.5x, which is lower than the industry average of 18.5x. While IRO 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 explain what the P/E ratio is as well as what you should look out for when using it.
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 dollar of the company’s earnings.
P/E Calculation for IRO
Price-Earnings Ratio = Price per share ÷ Earnings per share
IRO Price-Earnings Ratio = $0.24 ÷ $0.0522 = 4.5x
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 IRO, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. IRO’s P/E of 4.5 is lower than its industry peers (18.5), which implies that each dollar of IRO’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 11 Food companies in CA including Imperial Ginseng Products, High Liner Foods and Ginger Beef. One could put it like this: the market is pricing IRO as if it is a weaker company than the average company in its industry.
A few caveats
However, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to IRO, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with IRO, 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 IRO to are fairly valued by the market. If this does not hold, there is a possibility that IRO’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on IRO, 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for IRO’s future growth? Take a look at our free research report of analyst consensus for IRO’s outlook.
- Past Track Record: Has IRO been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of IRO’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past 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. For errors that warrant correction please contact the editor at email@example.com.