The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Kinross Gold Corporation (TSE:K) is currently trading at a trailing P/E of 9.6, which is close to the industry average of 9.6. While this makes K appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
What you need to know about the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 K
Price-Earnings Ratio = Price per share ÷ Earnings per share
K Price-Earnings Ratio = $2.97 ÷ $0.309 = 9.6x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as K, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Kinross Gold Corporation (TSE:K) is currently trading at a trailing P/E of 9.6, which is close to the industry average of 9.6. This multiple is a median of profitable companies of 25 Metals and Mining companies in CA including Winston Resources, European Electric Metals and Sherritt International. You can think of it like this: the market is suggesting that K has similar prospects to its peers in the same industry.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to K, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with K, 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 K to are fairly valued by the market. If this does not hold, there is a possibility that K’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 K, 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for K’s future growth? Take a look at our free research report of analyst consensus for K’s outlook.
- Past Track Record: Has K 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 K’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 firstname.lastname@example.org.