Should You Be Tempted To Buy A O Smith Corporation (AOS) Because Of Its PE Ratio?
A O Smith Corporation (NYSE:AOS) is trading with a trailing P/E of 29.6x, which is lower than the industry average of 33.3x. While AOS 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 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 A. O. Smith
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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.
Formula
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for AOS
Price per share = 59
Earnings per share = 1.993
∴ Price-Earnings Ratio = 59 ÷ 1.993 = 29.6x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to AOS, 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 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.
At 29.6x, AOS’s P/E is lower than its industry peers (33.3x). This implies that investors are undervaluing each dollar of AOS’s earnings. Therefore, according to this analysis, AOS is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy AOS, 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 AOS. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing lower risk firms with AOS, then AOS’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with AOS. In this case, AOS’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing AOS to are fairly valued by the market. If this assumption is violated, AOS'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? Since you may have already conducted your due diligence on AOS, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.
Are you a potential investor? If you are considering investing in AOS, 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 A. O. Smith 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.
