Edison SA. (WSE:EDN) is currently trading at a trailing P/E of 2.2x, which is lower than the industry average of 24.9x. While EDN 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. See our latest analysis for Edison
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.
P/E Calculation for EDN
Price-Earnings Ratio = Price per share ÷ Earnings per share
EDN Price-Earnings Ratio = PLN1.84 ÷ PLN0.845 = 2.2x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to EDN, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. EDN’s P/E of 2.2x is lower than its industry peers (24.9x), which implies that each dollar of EDN’s earnings is being undervalued by investors. As such, our analysis shows that EDN represents an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy EDN, 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 EDN, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with EDN, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing EDN to are fairly valued by the market. If this is violated, EDN’s P/E may be lower than its peers as they are actually overvalued by investors.
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 EDN 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 urge you to complete your research by taking a look at the following:
Financial Health: Is EDN’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 EDN 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 EDN’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 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.