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.
Indigo Books & Music Inc (TSE:IDG) is currently trading at a trailing P/E of 31.6, which is higher than the industry average of 14.3. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. In this article, I will break down what the P/E ratio is, how to interpret it and what other factors to keep in mind.
See our latest analysis for Indigo Books & Music
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.
Formula
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for IDG
Price per share = CA$13.7
Earnings per share = CA$0.433
∴ Price-Earnings Ratio = CA$13.7 ÷ CA$0.433 = 31.6x
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 IDG, such as capital structure and profitability. 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.
Since IDG’s P/E of 31.6 is higher than its industry peers (14.3), it means that investors are paying more for each dollar of IDG’s earnings. This multiple is a median of profitable companies of 6 Specialty Retail companies in CA including Advent-AWI Holdings, BMTC Group and Leon’s Furniture. You could also say that the market is suggesting that IDG has a stronger business than the average comparable company.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to IDG. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where Indigo Books & Music Inc is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. We should also be aware that the stocks we are comparing to IDG may not be fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.
What this means for you:
Since you may have already conducted your due diligence on IDG, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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 IDG’s future growth? Take a look at our free research report of analyst consensus for IDG’s outlook.
- Past Track Record: Has IDG 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 IDG’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 editorial-team@simplywallst.com.