Alkane Resources Limited (ASX:ALK) is currently trading at a trailing P/E of 12.6x, which is lower than the industry average of 13.5x. While ALK might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Alkane Resources
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 ALK
Price per share = A$0.31
Earnings per share = A$0.024
∴ Price-Earnings Ratio = A$0.31 ÷ A$0.024 = 12.6x
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 ALK, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
ALK’s P/E of 12.6x is lower than its industry peers (13.5x), which implies that each dollar of ALK’s earnings is being undervalued by investors. Therefore, according to this analysis, ALK is an under-priced stock.
A few caveats
While our conclusion might prompt you to buy ALK 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 ALK. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with ALK, then investors would naturally value ALK at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with ALK, investors would also value ALK at a lower price since it is a lower growth investment. Both scenarios would explain why ALK has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing ALK to are fairly valued by the market. If this does not hold, there is a possibility that ALK’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on ALK, the undervaluation of the stock may mean it is a good time to top up on 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:
- Future Outlook: What are well-informed industry analysts predicting for ALK’s future growth? Take a look at our free research report of analyst consensus for ALK’s outlook.
- Past Track Record: Has ALK 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 ALK’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.