Warpaint London PLC (AIM:W7L) is trading with a trailing P/E of 39.5x, which is higher than the industry average of 18.2x. While this makes W7L appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. 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. View our latest analysis for Warpaint London
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 pound of the company’s earnings.
P/E Calculation for W7L
Price-Earnings Ratio = Price per share ÷ Earnings per share
W7L Price-Earnings Ratio = £2 ÷ £0.051 = 39.5x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to W7L, 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 W7L’s P/E of 39.5x is higher than its industry peers (18.2x), it means that investors are paying more than they should for each dollar of W7L’s earnings. Therefore, according to this analysis, W7L is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your W7L shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to W7L. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with W7L, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing W7L to are fairly valued by the market. If this does not hold, there is a possibility that W7L’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.