Ambition Group Limited (ASX:AMB) is currently trading at a trailing P/E of 30.6x, which is higher than the industry average of 18.9x. While this makes AMB 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. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Ambition Group
Breaking down the P/E 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 dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for AMB
Price per share = A$0.16
Earnings per share = A$0.005
∴ Price-Earnings Ratio = A$0.16 ÷ A$0.005 = 30.6x
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 AMB, 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.
At 30.6x, AMB’s P/E is higher than its industry peers (18.9x). This implies that investors are overvaluing each dollar of AMB’s earnings. Therefore, according to this analysis, AMB is an over-priced stock.
A few caveats
Before you jump to the conclusion that AMB should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to AMB. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared riskier firms with AMB, then investors would naturally value AMB at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with AMB, investors would also value AMB at a higher price since it is a higher growth investment. Both scenarios would explain why AMB has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing AMB to are fairly valued by the market. If this assumption is violated, AMB’s P/E may be higher than its peers because its peers are actually undervalued by investors.
What this means for you:
Since you may have already conducted your due diligence on AMB, the overvaluation of the stock may mean it is a good time to reduce 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following:
- Financial Health: Is AMB’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has AMB been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of AMB’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.