Rafako SA. (WSE:RFK) trades with a trailing P/E of 25.1x, which is higher than the industry average of 16.6x. While RFK might seem like a stock to avoid or sell if you own it, 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. Check out our latest analysis for Rafako
What you need to know about the P/E ratio
P/E is a popular ratio used for relative valuation. 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 RFK
Price per share = PLN4.25
Earnings per share = PLN0.17
∴ Price-Earnings Ratio = PLN4.25 ÷ PLN0.17 = 25.1x
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 RFK, 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 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.
Since RFK’s P/E of 25.1x is higher than its industry peers (16.6x), it means that investors are paying more than they should for each dollar of RFK’s earnings. Therefore, according to this analysis, RFK is an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your RFK shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to RFK. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing riskier firms with RFK, then RFK’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with RFK. In this case, RFK’s P/E would be higher since investors would also reward RFK’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing RFK to are fairly valued by the market. If this assumption is violated, RFK’s P/E may be higher than its peers because its peers are actually undervalued by investors.
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 rebalance your portfolio and reduce your holdings in RFK. 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 RFK’s future growth? Take a look at our free research report of analyst consensus for RFK’s outlook.
- Past Track Record: Has RFK 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 RFK’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.