I am writing today to help inform people who are new to the stock market and want to begin learning the link between American Railcar Industries Inc (NASDAQ:ARII)’s fundamentals and stock market performance.
American Railcar Industries Inc (NASDAQ:ARII) trades with a trailing P/E of 5.2x, which is lower than the industry average of 22.4x. While ARII 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. View out our latest analysis for American Railcar Industries
Demystifying the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 ARII
Price per share = $39.24
Earnings per share = $7.577
∴ Price-Earnings Ratio = $39.24 ÷ $7.577 = 5.2x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as ARII, 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 ARII’s P/E of 5.2x is lower than its industry peers (22.4x), it means that investors are paying less than they should for each dollar of ARII’s earnings. Therefore, according to this analysis, ARII is an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy ARII, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to ARII. 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 ARII, then ARII’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 ARII, ARII’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 ARII to are fairly valued by the market. If this assumption is violated, ARII’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on ARII, 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:
- Future Outlook: What are well-informed industry analysts predicting for ARII’s future growth? Take a look at our free research report of analyst consensus for ARII’s outlook.
- Past Track Record: Has ARII 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 ARII’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.