Is It Time To Buy Hammond Power Solutions Inc (TSE:HPS.A) Based Off Its PE Ratio?

Hammond Power Solutions Inc (TSX:HPS.A) trades with a trailing P/E of 17.8x, which is lower than the industry average of 18.7x. While HPS.A 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. Check out our latest analysis for Hammond Power Solutions

Breaking down the Price-Earnings 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.

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against 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 HPS.A, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.

HPS.A’s P/E of 17.8x is lower than its industry peers (18.7x), which implies that each dollar of HPS.A’s earnings is being undervalued by investors. As such, our analysis shows that HPS.A represents an under-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to buy HPS.A immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to HPS.A. 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 HPS.A, then HPS.A’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 HPS.A. In this case, HPS.A’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 HPS.A to are fairly valued by the market. If this assumption does not hold true, HPS.A’s lower P/E ratio may be 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 HPS.A, 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 urge you to complete your research by taking a look at the following:

1. Financial Health: Is HPS.A’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.
2. Past Track Record: Has HPS.A 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 HPS.A's historicals for more clarity.
3. 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.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.