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Does Leon’s Furniture Limited’s (TSE:LNF) PE Ratio Signal A Buying Opportunity?

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.

Leon’s Furniture Limited (TSE:LNF) trades with a trailing P/E of 12.4x, which is lower than the industry average of 19.6x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.

Check out our latest analysis for Leon’s Furniture

Breaking down the Price-Earnings ratio

TSX:LNF PE PEG Gauge August 26th 18
TSX:LNF PE PEG Gauge August 26th 18

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 LNF

Price-Earnings Ratio = Price per share ÷ Earnings per share

LNF Price-Earnings Ratio = CA$17.81 ÷ CA$1.435 = 12.4x

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 LNF, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 12.4x, LNF’s P/E is lower than its industry peers (19.6x). This implies that investors are undervaluing each dollar of LNF’s earnings. This multiple is a median of profitable companies of 6 Specialty Retail companies in CA including Advent-AWI Holdings, BMTC Group and Sleep Country Canada Holdings. As such, our analysis shows that LNF represents an under-priced stock.

A few caveats

However, before you rush out to buy LNF, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to LNF. 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 LNF, 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 LNF to are fairly valued by the market. If this is violated, LNF’s P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

Since you may have already conducted your due diligence on LNF, 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:

  1. Future Outlook: What are well-informed industry analysts predicting for LNF’s future growth? Take a look at our free research report of analyst consensus for LNF’s outlook.

  2. Past Track Record: Has LNF 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 LNF’s historicals for more clarity.

  3. 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 editorial-team@simplywallst.com.

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