Alpha Financial Markets Consulting UK Limited (AIM:AFM) is trading with a trailing P/E of 0x, which is lower than the industry average of 19.2x. While this makes AFM appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Alpha Financial Markets Consulting UK
What you need to know about the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 pound of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for AFM
Price per share = £1.65
Earnings per share = £64.649
∴ Price-Earnings Ratio = £1.65 ÷ £64.649 = 0x
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 AFM, such as capital structure and profitability. 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.
Since AFM’s P/E of 0x is lower than its industry peers (19.2x), it means that investors are paying less than they should for each dollar of AFM’s earnings. Therefore, according to this analysis, AFM is an under-priced stock.
A few caveats
However, before you rush out to buy AFM, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to AFM. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared higher growth firms with AFM, then AFM’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with AFM, AFM’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing AFM to are fairly valued by the market. If this assumption does not hold true, AFM’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 AFM, 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:
1. Future Outlook: What are well-informed industry analysts predicting for AFM’s future growth? Take a look at our free research report of analyst consensus for AFM’s outlook.
2. Past Track Record: Has AFM 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 AFM’s historicals for more clarity.
3. 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.