This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Jersey Electricity plc (LON:JEL) is currently trading at a trailing P/E of 12.3x, which is lower than the industry average of 13.4x. While this makes JEL 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.
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 JEL
Price per share = £4.52
Earnings per share = £0.366
∴ Price-Earnings Ratio = £4.52 ÷ £0.366 = 12.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 JEL, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will 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 12.3x, JEL’s P/E is lower than its industry peers (13.4x). This implies that investors are undervaluing each dollar of JEL’s earnings. Since the Electric Utilities sector in GB is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as OPG Power Ventures, SSE and . As such, our analysis shows that JEL represents an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy JEL, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to JEL. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with JEL, then investors would naturally value JEL at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with JEL, investors would also value JEL at a lower price since it is a lower growth investment. Both scenarios would explain why JEL has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing JEL to are fairly valued by the market. If this assumption does not hold true, JEL’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
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 JEL 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for JEL’s future growth? Take a look at our free research report of analyst consensus for JEL’s outlook.
- Past Track Record: Has JEL 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 JEL’s historicals for more clarity.
- 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.