This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
International Speedway Corporation (NASDAQ:ISCA) is trading with a trailing P/E of 7.5x, which is lower than the industry average of 23.8x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
What you need to know about the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 ISCA
Price per share = $44.55
Earnings per share = $5.928
∴ Price-Earnings Ratio = $44.55 ÷ $5.928 = 7.5x
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 ISCA, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
At 7.5x, ISCA’s P/E is lower than its industry peers (23.8x). This implies that investors are undervaluing each dollar of ISCA’s earnings. This multiple is a median of profitable companies of 23 Hospitality companies in US including Evolution Technology Resources, U-Swirl and China Enterprises. As such, our analysis shows that ISCA represents an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that ISCA represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to ISCA. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with ISCA, then investors would naturally value ISCA at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with ISCA, investors would also value ISCA at a lower price since it is a lower growth investment. Both scenarios would explain why ISCA has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing ISCA to are fairly valued by the market. If this assumption is violated, ISCA’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 ISCA. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for ISCA’s future growth? Take a look at our free research report of analyst consensus for ISCA’s outlook.
- Past Track Record: Has ISCA 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 ISCA’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.