Acorn International Inc (NYSE:ATV) trades with a trailing P/E of 16.5x, which is lower than the industry average of 187.1x. While this makes ATV appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Acorn International
Breaking down the Price-Earnings 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for ATV
Price per share = 14.99
Earnings per share = 0.91
∴ Price-Earnings Ratio = 14.99 ÷ 0.91 = 16.5x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ATV, 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. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
Since ATV's P/E of 16.5x is lower than its industry peers (187.1x), it means that investors are paying less than they should for each dollar of ATV's earnings. As such, our analysis shows that ATV represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy ATV immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to ATV. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with ATV, then investors would naturally value ATV at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with ATV, investors would also value ATV at a lower price since it is a lower growth investment. Both scenarios would explain why ATV has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing ATV to are fairly valued by the market. If this assumption is violated, ATV's P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of ATV to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If ATV has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Acorn International for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
To help readers see pass 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.