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This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Liontown Resources Limited (ASX:LTR) is trading with a trailing P/E of 19.5, which is higher than the industry average of 11.4. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 LTR
Price-Earnings Ratio = Price per share ÷ Earnings per share
LTR Price-Earnings Ratio = A$0.028 ÷ A$0.00144 = 19.5x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to LTR, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. LTR’s P/E of 19.5 is higher than its industry peers (11.4), which implies that each dollar of LTR’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Metals and Mining companies in AU including Gladiator Resources, Titan Minerals and Aeris Resources. You could also say that the market is suggesting that LTR is a stronger business than the average comparable company.
Assumptions to watch out for
However, you should be aware that this analysis makes certain assumptions. The first is that our “similar companies” are actually similar to LTR. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where Liontown Resources Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. We should also be aware that the stocks we are comparing to LTR may not be fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in LTR. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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:
Financial Health: Are LTR’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.
Past Track Record: Has LTR 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 LTR’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.