Should You Be Tempted To Buy Royal Mail plc (LON:RMG) At Its Current PE Ratio?

Royal Mail plc (LSE:RMG) trades with a trailing P/E of 15.2x, which is lower than the industry average of 20.8x. While RMG might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Royal Mail

Breaking down the Price-Earnings ratio

A common ratio used for relative valuation is the P/E ratio. 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.

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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to RMG, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.

RMG’s P/E of 15.2x is lower than its industry peers (20.8x), which implies that each dollar of RMG’s earnings is being undervalued by investors. Therefore, according to this analysis, RMG is an under-priced stock.

Assumptions to be aware of

Before you jump to the conclusion that RMG 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 RMG. 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 RMG, then RMG’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 RMG, RMG’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 RMG to are fairly valued by the market. If this does not hold, there is a possibility that RMG’s P/E is lower because firms in our peer group are being overvalued by the market.

What this means for you:

You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to RMG. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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. Future Outlook: What are well-informed industry analysts predicting for RMG’s future growth? Take a look at our free research report of analyst consensus for RMG’s outlook.
• 2. Past Track Record: Has RMG 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 RMG'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.