Burford Capital Limited (AIM:BUR) is currently trading at a trailing P/E of 16.2x, which is lower than the industry average of 21.8x. While this makes BUR appear like a great stock to buy, 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 Burford Capital
Demystifying 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. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for BUR
Price per share = 11.25
Earnings per share = 0.915
∴ Price-Earnings Ratio = 11.25 ÷ 0.915 = 16.2x
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. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to BUR, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
At 16.2x, BUR’s P/E is lower than its industry peers (21.8x). This implies that investors are undervaluing each dollar of BUR’s earnings. Therefore, according to this analysis, BUR is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy BUR 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 BUR. 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 BUR, then BUR’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 BUR, BUR’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 BUR to are fairly valued by the market. If this does not hold, there is a possibility that BUR’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on BUR, 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.
Are you a potential investor? If BUR 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 Burford Capital 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.