This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Faes Farma SA (BME:FAE) trades with a trailing P/E of 20.1x, which is lower than the industry average of 20.3x. While FAE might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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
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 FAE
Price per share = €3.84
Earnings per share = €0.191
∴ Price-Earnings Ratio = €3.84 ÷ €0.191 = 20.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to FAE, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. 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.
FAE’s P/E of 20.1x is lower than its industry peers (20.3x), which implies that each dollar of FAE’s earnings is being undervalued by investors. Since the Pharmaceuticals sector in ES is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as Laboratorio Reig Jofre, Bayer and Laboratorios Farmaceuticos Rovi. As such, our analysis shows that FAE represents an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy FAE 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 FAE. 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 FAE, then investors would naturally value FAE at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with FAE, investors would also value FAE at a lower price since it is a lower growth investment. Both scenarios would explain why FAE has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing FAE to are fairly valued by the market. If this assumption does not hold true, FAE’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on FAE, the undervaluation of the stock may mean it is a good time to top up on 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for FAE’s future growth? Take a look at our free research report of analyst consensus for FAE’s outlook.
- Past Track Record: Has FAE 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 FAE’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.