I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Argonaut Gold Inc (TSE:AR) is currently trading at a trailing P/E of 12.3x, which is higher than the industry average of 10.9x. 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. See our latest analysis for Argonaut Gold
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for AR
Price per share = $1.67
Earnings per share = $0.136
∴ Price-Earnings Ratio = $1.67 ÷ $0.136 = 12.3x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 AR, 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.
AR’s P/E of 12.3x is higher than its industry peers (10.9x), which implies that each dollar of AR’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Metals and Mining companies in CA including Knick Exploration, Winston Resources and Stelco Holdings. Therefore, according to this analysis, AR is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your AR shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to AR. 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 riskier firms with AR, then AR’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with AR. In this case, AR’s P/E would be higher since investors would also reward AR’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing AR to are fairly valued by the market. If this assumption is violated, AR’s P/E may be higher than its peers because its peers are actually undervalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to AR. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 AR’s future growth? Take a look at our free research report of analyst consensus for AR’s outlook.
- Past Track Record: Has AR 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 AR’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.