Argos Resources Limited (AIM:ARG) trades with a trailing P/E of 167.9x, which is higher than the industry average of 24.1x. While this makes ARG appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, 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 Argos Resources
Breaking down 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 pound of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for ARG
Price per share = $0.05
Earnings per share = $0
∴ Price-Earnings Ratio = $0.05 ÷ $0 = 167.9x
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 ARG, such as size and country of operation. 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.
ARG’s P/E of 167.9x is higher than its industry peers (24.1x), which implies that each dollar of ARG’s earnings is being overvalued by investors. Therefore, according to this analysis, ARG is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that ARG should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to ARG. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with ARG, then investors would naturally value ARG at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with ARG, investors would also value ARG at a higher price since it is a higher growth investment. Both scenarios would explain why ARG has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing ARG to are fairly valued by the market. If this does not hold, there is a possibility that ARG’s P/E is higher because firms in our peer group are being undervalued by the market.
What this means for you:Since you may have already conducted your due diligence on ARG, 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 urge you to complete your research by taking a look at the following:
1. Financial Health: Is ARG’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 ARG 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 ARG’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.