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 learn about the link between company’s fundamentals and stock market performance.
Farmmi Inc (NASDAQ:FAMI) is currently trading at a trailing P/E of 14.1x, which is lower than the industry average of 17.9x. 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 FAMI
Price-Earnings Ratio = Price per share ÷ Earnings per share
FAMI Price-Earnings Ratio = $4.6 ÷ $0.327 = 14.1x
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 FAMI, 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. FAMI’s P/E of 14.1 is lower than its industry peers (17.9), which implies that each dollar of FAMI’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 25 Food companies in US including Royal Hawaiian Orchards, Kaibo Foods and China Modern Agricultural Information. You can think of it like this: the market is suggesting that FAMI is a weaker business than the average comparable company.
Assumptions to watch out for
However, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to FAMI, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with FAMI, 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 FAMI to are fairly valued by the market. If this does not hold true, FAMI’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on FAMI, 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 FAMI’s future growth? Take a look at our free research report of analyst consensus for FAMI’s outlook.
- Financial Health: Are FAMI’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- 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.