Pele Mountain Resources Inc (TSXV:GEM) is currently trading at a trailing P/E of 2x, which is lower than the industry average of 10.5x. While GEM 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. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Pele Mountain Resources
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for GEM
Price-Earnings Ratio = Price per share ÷ Earnings per share
GEM Price-Earnings Ratio = CA$0.05 ÷ CA$0.025 = 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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as GEM, 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. GEM’s P/E of 2x is lower than its industry peers (10.5x), which implies that each dollar of GEM’s earnings is being undervalued by investors. As such, our analysis shows that GEM represents an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that GEM 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 GEM. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with GEM, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing GEM to are fairly valued by the market. If this does not hold, there is a possibility that GEM’s P/E is lower because our peer group is overvalued by the market.
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.