This analysis is intended to introduce important early concepts to people who are starting to invest and want to better understand how you can grow your money by investing in Allegra Orthopaedics Limited (ASX:AMT).
Allegra Orthopaedics Limited (ASX:AMT) is currently trading at a trailing P/E of 87.4x, which is higher than the industry average of 49.2x. While this makes AMT 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View out our latest analysis for Allegra Orthopaedics
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 AMT
Price per share = A$0.13
Earnings per share = A$0.00149
∴ Price-Earnings Ratio = A$0.13 ÷ A$0.00149 = 87.4x
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 AMT, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. 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.
AMT’s P/E of 87.4x is higher than its industry peers (49.2x), which implies that each dollar of AMT’s earnings is being overvalued by investors. Therefore, according to this analysis, AMT is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your AMT shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to AMT. 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 AMT, then investors would naturally value AMT at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with AMT, investors would also value AMT at a higher price since it is a higher growth investment. Both scenarios would explain why AMT has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing AMT to are fairly valued by the market. If this assumption is violated, AMT’s P/E may be higher than its peers because its peers are actually undervalued 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 rebalance your portfolio and reduce your holdings in AMT. 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 AMT’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 AMT 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 AMT’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.