This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.
IPL Plastics Inc (TSE:IPLP) is trading with a trailing P/E of 79.1x, which is higher than the industry average of 22.9x. While this makes IPLP appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
What you need to know about the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 IPLP
Price per share = $10.15
Earnings per share = $0.128
∴ Price-Earnings Ratio = $10.15 ÷ $0.128 = 79.1x
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. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to IPLP, 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.
IPLP’s P/E of 79.1x is higher than its industry peers (22.9x), which implies that each dollar of IPLP’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 6 Packaging companies in CA including Cascades, Imaflex and Intertape Polymer Group. As such, our analysis shows that IPLP represents an over-priced stock.
A few caveats
However, before you rush out to sell your IPLP shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to IPLP. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with IPLP, then investors would naturally value IPLP at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with IPLP, investors would also value IPLP at a higher price since it is a higher growth investment. Both scenarios would explain why IPLP has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing IPLP to are fairly valued by the market. If this assumption is violated, IPLP’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 IPLP. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for IPLP’s future growth? Take a look at our free research report of analyst consensus for IPLP’s outlook.
- Financial Health: Are IPLP’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.
- 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 firstname.lastname@example.org.