Riocan Real Estate Investment Trust (TSX:REI.UN) is currently trading at a trailing P/E of 10.9x, which is lower than the industry average of 11.8x. 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. View our latest analysis for Riocan Real Estate Investment Trust
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for REI.UN
Price per share = 24.71
Earnings per share = 2.276
∴ Price-Earnings Ratio = 24.71 ÷ 2.276 = 10.9x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to REI.UN, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
Since REI.UN’s P/E of 10.9x is lower than its industry peers (11.8x), it means that investors are paying less than they should for each dollar of REI.UN’s earnings. Therefore, according to this analysis, REI.UN is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy REI.UN immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to REI.UN. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with REI.UN, then REI.UN’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with REI.UN, REI.UN’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing REI.UN to are fairly valued by the market. If this assumption does not hold true, REI.UN’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to REI.UN. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.
Are you a potential investor? If you are considering investing in REI.UN, 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 Riocan Real Estate Investment Trust 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.