Alio Gold Inc (TSX:ALO) is trading with a trailing P/E of 8.2x, which is lower than the industry average of 10.9x. 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 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 Alio Gold
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 ALO
Price-Earnings Ratio = Price per share ÷ Earnings per share
ALO Price-Earnings Ratio = $1.78 ÷ $0.218 = 8.2x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as ALO, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. ALO’s P/E of 8.2x is lower than its industry peers (10.9x), which implies that each dollar of ALO’s earnings is being undervalued by investors. As such, our analysis shows that ALO represents an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy ALO immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to ALO. 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 ALO, 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 ALO to are fairly valued by the market. If this does not hold, there is a possibility that ALO’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on ALO, 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. 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:
- Future Outlook: What are well-informed industry analysts predicting for ALO’s future growth? Take a look at our free research report of analyst consensus for ALO’s outlook.
- Past Track Record: Has ALO 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 ALO’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.