Dominion Diamond Corporation (TSX:DDC) trades with a trailing P/E of 20.2x, which is lower than the industry average of 38.5x. 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 explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Dominion Diamond
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for DDC
Price per share = 17.42
Earnings per share = 0.705
∴ Price-Earnings Ratio = 17.42 ÷ 0.705 = 20.2x
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 DDC, 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. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
Since DDC's P/E of 20.2x is lower than its industry peers (38.5x), it means that investors are paying less than they should for each dollar of DDC's earnings. As such, our analysis shows that DDC represents an under-priced stock.
A few caveats
However, before you rush out to buy DDC, 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 DDC. 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 DDC, then investors would naturally value DDC at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with DDC, investors would also value DDC at a lower price since it is a lower growth investment. Both scenarios would explain why DDC has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing DDC to are fairly valued by the market. If this does not hold, there is a possibility that DDC’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to DDC. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.
Are you a potential investor? If you are considering investing in DDC, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
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 Dominion Diamond 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.