The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Ascendant Resources Inc (TSE:ASND) trades with a trailing P/E of 4.3, which is lower than the industry average of 9.8. While this makes ASND appear like a good stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 ASND
Price per share = $0.55
Earnings per share = $0.127
∴ Price-Earnings Ratio = $0.55 ÷ $0.127 = 4.3x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as ASND, 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.
At 4.3, ASND’s P/E is lower than its industry peers (9.8). This implies that investors are undervaluing each dollar of ASND’s earnings. This multiple is a median of profitable companies of 25 Metals and Mining companies in CA including Winston Resources, Sulliden Mining Capital and Sherritt International. One could put it like this: the market is pricing ASND as if it is a weaker company than the average company in its industry.
A few caveats
Before you jump to conclusions it is important to realise that our assumptions rests on two important assertions. The first is that our “similar companies” are actually similar to ASND. 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 ASND, then investors would naturally value ASND at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with ASND, investors would also value ASND at a lower price since it is a lower growth investment. Both scenarios would explain why ASND has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing ASND to are fairly valued by the market. If this assumption does not hold true, ASND’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 ASND 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:
- Future Outlook: What are well-informed industry analysts predicting for ASND’s future growth? Take a look at our free research report of analyst consensus for ASND’s outlook.
- Past Track Record: Has ASND 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 ASND’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.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.