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Should You Be Tempted To Buy International Parkside Products Inc (CVE:IPD) Because Of Its PE Ratio?

International Parkside Products Inc (TSXV:IPD) trades with a trailing P/E of 6.2x, which is lower than the industry average of 16.3x. While IPD 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for International Parkside Products

Demystifying the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.

Formula

Price-Earnings Ratio = Price per share ÷ Earnings per share

P/E Calculation for IPD

Price per share = CA\$0.14

Earnings per share = CA\$0.023

∴ Price-Earnings Ratio = CA\$0.14 ÷ CA\$0.023 = 6.2x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 IPD, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. 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 6.2x, IPD’s P/E is lower than its industry peers (16.3x). This implies that investors are undervaluing each dollar of IPD’s earnings. As such, our analysis shows that IPD represents an under-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to buy IPD immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to IPD. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with IPD, then investors would naturally value IPD at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with IPD, investors would also value IPD at a lower price since it is a lower growth investment. Both scenarios would explain why IPD has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing IPD to are fairly valued by the market. If this does not hold, there is a possibility that IPD’s P/E is lower 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 IPD 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 urge you to complete your research by taking a look at the following:

1. Financial Health: Is IPD’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 IPD 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 IPD’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.