I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Azucar Minerals Ltd (CVE:AMZ) is currently trading at a trailing P/E of 8.3, which is lower than the industry average of 9.6. While this makes AMZ 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 AMZ
Price per share = CA$0.71
Earnings per share = CA$0.0858
∴ Price-Earnings Ratio = CA$0.71 ÷ CA$0.0858 = 8.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AMZ, 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.
AMZ’s P/E of 8.3 is lower than its industry peers (9.6), which implies that each dollar of AMZ’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 25 Metals and Mining companies in CA including Winston Resources, European Electric Metals and Sherritt International. You can think of it like this: the market is suggesting that AMZ is a weaker business than the average comparable company.
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 AMZ. 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 lower risk firms with AMZ, then AMZ’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with AMZ. In this case, AMZ’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing AMZ to are fairly valued by the market. If this assumption does not hold true, AMZ’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 AMZ 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:
- Financial Health: Are AMZ’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.
- Past Track Record: Has AMZ 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 AMZ’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.