I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
A2A SpA (BIT:A2A) is trading with a trailing P/E of 12.5x, which is lower than the industry average of 12.6x. While A2A 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
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 dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for A2A
Price per share = €1.56
Earnings per share = €0.125
∴ Price-Earnings Ratio = €1.56 ÷ €0.125 = 12.5x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to A2A, such as capital structure and profitability. 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.
At 12.5x, A2A’s P/E is lower than its industry peers (12.6x). This implies that investors are undervaluing each dollar of A2A’s earnings. This multiple is a median of profitable companies of 6 Integrated Utilities companies in IT including E.ON, Iren and ACEA. Therefore, according to this analysis, A2A is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that A2A represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to A2A. 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 A2A, then investors would naturally value A2A at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with A2A, investors would also value A2A at a lower price since it is a lower growth investment. Both scenarios would explain why A2A has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing A2A to are fairly valued by the market. If this assumption does not hold true, A2A’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 A2A 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 A2A’s future growth? Take a look at our free research report of analyst consensus for A2A’s outlook.
- Past Track Record: Has A2A 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 A2A’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 firstname.lastname@example.org.