Hotcopper Holdings Limited (ASX:HOT) is currently trading at a trailing P/E of 26.4x, which is lower than the industry average of 29x. 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 explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Hotcopper Holdings
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for 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 HOT
Price per share = A$0.24
Earnings per share = A$0.009
∴ Price-Earnings Ratio = A$0.24 ÷ A$0.009 = 26.4x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as HOT, such as size and country of operation. 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.
HOT’s P/E of 26.4x is lower than its industry peers (29x), which implies that each dollar of HOT’s earnings is being undervalued by investors. Therefore, according to this analysis, HOT is an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy HOT 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 HOT. 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 HOT, then investors would naturally value HOT at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with HOT, investors would also value HOT at a lower price since it is a lower growth investment. Both scenarios would explain why HOT has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing HOT to are fairly valued by the market. If this assumption does not hold true, HOT’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
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 HOT 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 HOT’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 HOT 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 HOT’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.