Omni Market Tide Limited (DB:A4B) trades with a trailing P/E of 20.2x, which is lower than the industry average of 36.4x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Omni Market Tide
Demystifying 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. 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 A4B
Price per share = A$0.01
Earnings per share = A$0.001
∴ Price-Earnings Ratio = A$0.01 ÷ A$0.001 = 20.2x
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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as A4B, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will 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.
A4B’s P/E of 20.2x is lower than its industry peers (36.4x), which implies that each dollar of A4B’s earnings is being undervalued by investors. Therefore, according to this analysis, A4B is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy A4B immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to A4B. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with A4B, then investors would naturally value A4B at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with A4B, investors would also value A4B at a lower price since it is a lower growth investment. Both scenarios would explain why A4B has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing A4B to are fairly valued by the market. If this assumption is violated, A4B’s P/E may be lower than its peers because its peers are actually overvalued 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 add more of A4B 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: Is A4B’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.