This article is intended for those of you who are at the beginning of your investing journey and want to better understand how you can grow your money by investing in Ariadne Australia Limited (ASX:ARA).
Ariadne Australia Limited (ASX:ARA) is currently trading at a trailing P/E of 13.7x, which is lower than the industry average of 15.6x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Ariadne Australia
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 ARA
Price per share = A$0.68
Earnings per share = A$0.0493
∴ Price-Earnings Ratio = A$0.68 ÷ A$0.0493 = 13.7x
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 ARA, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. 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.
At 13.7x, ARA’s P/E is lower than its industry peers (15.6x). This implies that investors are undervaluing each dollar of ARA’s earnings. As such, our analysis shows that ARA represents an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy ARA immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to ARA. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing lower risk firms with ARA, then ARA’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with ARA. In this case, ARA’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing ARA to are fairly valued by the market. If this assumption is violated, ARA’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of ARA to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 ARA’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 ARA 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 ARA’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.