West Wits Mining Limited (ASX:WWI) is currently trading at a trailing P/E of 21.1x, which is higher than the industry average of 14.3x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for West Wits Mining
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 WWI
Price per share = A$0.02
Earnings per share = A$0.001
∴ Price-Earnings Ratio = A$0.02 ÷ A$0.001 = 21.1x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 WWI, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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.
At 21.1x, WWI’s P/E is higher than its industry peers (14.3x). This implies that investors are overvaluing each dollar of WWI’s earnings. As such, our analysis shows that WWI represents an over-priced stock.
A few caveats
Before you jump to the conclusion that WWI should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to WWI. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared lower growth firms with WWI, then WWI’s P/E would naturally be higher since investors would reward WWI’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with WWI, WWI’s P/E would again be higher since investors would reward WWI’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing WWI to are fairly valued by the market. If this does not hold, there is a possibility that WWI’s P/E is higher because firms in our peer group are being undervalued by the market.
What this means for you:
Since you may have already conducted your due diligence on WWI, 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 urge you to complete your research by taking a look at the following:
- Financial Health: Is WWI’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 WWI 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 WWI’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.