Should You Sell Ambition Group Limited (ASX:AMB) At This PE Ratio?

I am writing today to help inform people who are new to the stock market and want to better understand how you can grow your money by investing in Ambition Group Limited (ASX:AMB).

Ambition Group Limited (ASX:AMB) is trading with a trailing P/E of 26.7x, which is higher than the industry average of 21.9x. 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. 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.

Breaking down 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.

Formula

Price-Earnings Ratio = Price per share ÷ Earnings per share

P/E Calculation for AMB

Price per share = A\$0.14

Earnings per share = A\$0.00524

∴ Price-Earnings Ratio = A\$0.14 ÷ A\$0.00524 = 26.7x

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 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.

AMB’s P/E of 26.7x is higher than its industry peers (21.9x), which implies that each dollar of AMB’s earnings is being overvalued by investors. As such, our analysis shows that AMB represents an over-priced stock.

A few caveats

While our conclusion might prompt you to sell your AMB shares 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 AMB. If this isn’t the case, the difference in P/E could be due to some 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 does not hold true, AMB’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.

What this means for you:

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 AMB. 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. 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:

1. 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.
2. 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.
3. 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.