Should You Be Tempted To Buy PayPoint plc (LSE:PAY) Because Of Its PE Ratio?
PayPoint plc (LSE:PAY) is currently trading at a trailing P/E of 10.7x, which is lower than the industry average of 21.5x. 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for PAY
Breaking down 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 pound of the company’s earnings.
P/E Calculation for PAY
Price-Earnings Ratio = Price per share ÷ Earnings per share
PAY Price-Earnings Ratio = 9.36 ÷ 0.875 = 10.7x
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 PAY, 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. PAY’s P/E of 10.7x is lower than its industry peers (21.5x), which implies that each dollar of PAY’s earnings is being undervalued by investors. Therefore, according to this analysis, PAY is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that PAY is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to PAY. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with PAY, 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 PAY to are fairly valued by the market. If this is violated, PAY's P/E may be lower than its peers as they 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 PAY 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 PAY 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 PayPoint 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.
