5G Networks Limited (ASX:5GN) trades with a trailing P/E of 70.6x, which is higher than the industry average of 18.5x. While this makes 5GN 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. Check out our latest analysis for 5G Networks
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for 5GN
Price per share = 0.25
Earnings per share = 0.004
∴ Price-Earnings Ratio = 0.25 ÷ 0.004 = 70.6x
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 5GN, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. 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.
5GN’s P/E of 70.6x is higher than its industry peers (18.5x), which implies that each dollar of 5GN’s earnings is being overvalued by investors. Therefore, according to this analysis, 5GN is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your 5GN shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to 5GN. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing riskier firms with 5GN, then 5GN’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with 5GN. In this case, 5GN’s P/E would be higher since investors would also reward 5GN’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing 5GN to are fairly valued by the market. If this assumption is violated, 5GN’s P/E may be higher than its peers because its peers are actually undervalued by investors.
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 overvaluation could signal a potential selling opportunity to reduce your exposure to 5GN. 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 5GN, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.
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 5G Networks 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.