Should You Be Tempted To Buy Parity Group plc (LON:PTY) Because Of Its PE Ratio?

Parity Group plc (AIM:PTY) trades with a trailing P/E of 6.3x, which is lower than the industry average of 25.6x. While this makes PTY 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 explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Parity Group

Breaking down the P/E ratio

The P/E ratio is one of many ratios used in relative valuation. 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 pound of the company’s earnings.

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as PTY, 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.

At 6.3x, PTY’s P/E is lower than its industry peers (25.6x). This implies that investors are undervaluing each dollar of PTY’s earnings. As such, our analysis shows that PTY represents an under-priced stock.

Assumptions to watch out for

However, before you rush out to buy PTY, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to PTY. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with PTY, then PTY’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 PTY, PTY’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 PTY to are fairly valued by the market. If this assumption is violated, PTY'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 PTY 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:

1. Financial Health: Is PTY’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.
2. Past Track Record: Has PTY 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 PTY'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.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.