This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Ossia International Limited (SGX:O08) is currently trading at a trailing P/E of 6.1x, which is lower than the industry average of 12.7x. While this makes O08 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 a popular ratio used for relative valuation. 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 dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for O08
Price per share = SGD0.10
Earnings per share = SGD0.0164
∴ Price-Earnings Ratio = SGD0.10 ÷ SGD0.0164 = 6.1x
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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as O08, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. 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 O08’s P/E of 6.1x is lower than its industry peers (12.7x), it means that investors are paying less than they should for each dollar of O08’s earnings. This multiple is a median of profitable companies of 6 Retail Distributors companies in SG including Thakral, YHI International and Jardine Cycle & Carriage. As such, our analysis shows that O08 represents an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that O08 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 O08. 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 O08, then investors would naturally value O08 at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with O08, investors would also value O08 at a lower price since it is a lower growth investment. Both scenarios would explain why O08 has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing O08 to are fairly valued by the market. If this assumption does not hold true, O08’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 O08, 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:
- Financial Health: Is O08’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.
- Past Track Record: Has O08 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 O08’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.