The content of this article will benefit those of you who are starting to educate yourself about investing in 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.
AerCap Holdings NV (NYSE:AER) trades with a trailing P/E of 8x, which is lower than the industry average of 14.6x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down the P/E 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 AER
Price per share = $55.33
Earnings per share = $6.953
∴ Price-Earnings Ratio = $55.33 ÷ $6.953 = 8x
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. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to AER, 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 8x, AER’s P/E is lower than its industry peers (14.6x). This implies that investors are undervaluing each dollar of AER’s earnings. This multiple is a median of profitable companies of 24 Trade Distributors companies in US including Star Struck, Spicers and General Steel Holdings. As such, our analysis shows that AER represents an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy AER immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to AER. 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 AER, then investors would naturally value AER at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with AER, investors would also value AER at a lower price since it is a lower growth investment. Both scenarios would explain why AER has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing AER to are fairly valued by the market. If this assumption is violated, AER’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to AER. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 AER’s future growth? Take a look at our free research report of analyst consensus for AER’s outlook.
- Past Track Record: Has AER 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 AER’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.