This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Babcock International Group PLC (LON:BAB) trades with a trailing P/E of 9.7x, which is lower than the industry average of 25.1x. While BAB might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 BAB
Price-Earnings Ratio = Price per share ÷ Earnings per share
BAB Price-Earnings Ratio = £6.48 ÷ £0.666 = 9.7x
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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as BAB, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 9.7, BAB’s P/E is lower than its industry peers (25.1). This implies that investors are undervaluing each dollar of BAB’s earnings. This multiple is a median of profitable companies of 24 Commercial Services companies in GB including Mortice, Communisis and Bilby. You can think of it like this: the market is suggesting that BAB is a weaker business than the average comparable company.
A few caveats
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to BAB. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with BAB, 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 BAB to are fairly valued by the market. If this does not hold true, BAB’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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 add more of BAB 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. 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 BAB’s future growth? Take a look at our free research report of analyst consensus for BAB’s outlook.
- Past Track Record: Has BAB 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 BAB’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.