Western Pacific Resources Corp (TSXV:WRP) is trading with a trailing P/E of 0.2x, which is lower than the industry average of 10.4x. While this makes WRP 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 explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for WRP
Breaking down the Price-Earnings 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for WRP
Price per share = 0.02
Earnings per share = 0.076
∴ Price-Earnings Ratio = 0.02 ÷ 0.076 = 0.2x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to WRP, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will 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 WRP’s P/E of 0.2x is lower than its industry peers (10.4x), it means that investors are paying less than they should for each dollar of WRP’s earnings. Therefore, according to this analysis, WRP is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that WRP represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to WRP. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with WRP, then investors would naturally value WRP at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with WRP, investors would also value WRP at a lower price since it is a lower growth investment. Both scenarios would explain why WRP has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing WRP to are fairly valued by the market. If this does not hold, there is a possibility that WRP’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 WRP, 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 WRP 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 Western Pacific Resources 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.