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.
Kirkland Lake Gold Ltd (TSE:KL) is currently trading at a trailing P/E of 23.3x, which is higher than the industry average of 10.9x. While this makes KL 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. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for KL
Price per share = $21.83
Earnings per share = $0.936
∴ Price-Earnings Ratio = $21.83 ÷ $0.936 = 23.3x
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 KL, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. 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.
KL’s P/E of 23.3x is higher than its industry peers (10.9x), which implies that each dollar of KL’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Metals and Mining companies in CA including Winston Resources, Knick Exploration and Stelco Holdings. Therefore, according to this analysis, KL is an over-priced stock.
A few caveats
Before you jump to the conclusion that KL should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to KL. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared lower growth firms with KL, then KL’s P/E would naturally be higher since investors would reward KL’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with KL, KL’s P/E would again be higher since investors would reward KL’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing KL to are fairly valued by the market. If this assumption is violated, KL’s P/E may be higher than its peers because its peers are actually undervalued by investors.
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 rebalance your portfolio and reduce your holdings in KL. 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 KL’s future growth? Take a look at our free research report of analyst consensus for KL’s outlook.
- Past Track Record: Has KL 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 KL’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 firstname.lastname@example.org.