I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Avast Plc (LON:AVST) trades with a trailing P/E of 16.8x, which is lower than the industry average of 33.6x. While this makes AVST appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
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. 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 AVST
Price per share = $3.14
Earnings per share = $0.187
∴ Price-Earnings Ratio = $3.14 ÷ $0.187 = 16.8x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to AVST, such as company lifetime and products sold. 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.
AVST’s P/E of 16.8x is lower than its industry peers (33.6x), which implies that each dollar of AVST’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Software companies in GB including Team17 Group, Petards Group and Micro Focus International. As such, our analysis shows that AVST represents an under-priced stock.
A few caveats
Before you jump to the conclusion that AVST 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 AVST. 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 AVST, then investors would naturally value AVST at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with AVST, investors would also value AVST at a lower price since it is a lower growth investment. Both scenarios would explain why AVST has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing AVST to are fairly valued by the market. If this assumption does not hold true, AVST’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 AVST, 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 AVST’s future growth? Take a look at our free research report of analyst consensus for AVST’s outlook.
- Financial Health: Are AVST’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.
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 email@example.com.