Bluebird Merchant Ventures Limited (LSE:BMV) is trading with a trailing P/E of 5x, which is lower than the industry average of 13.3x. 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. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Bluebird Merchant Ventures
Demystifying the P/E ratio
P/E is a popular ratio used for 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for BMV
Price per share = $0.04
Earnings per share = $0.008
∴ Price-Earnings Ratio = $0.04 ÷ $0.008 = 5x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 BMV, 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.
BMV’s P/E of 5x is lower than its industry peers (13.3x), which implies that each dollar of BMV’s earnings is being undervalued by investors. As such, our analysis shows that BMV represents an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that BMV represents the perfect buying opportunity, 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 BMV. 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 BMV, then BMV’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 BMV, BMV’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 BMV to are fairly valued by the market. If this assumption is violated, BMV’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on BMV, 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 highly recommend you to complete your research by taking a look at the following:
- Financial Health: Is BMV’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.