Acorn International Inc (NYSE:ATV) trades with a trailing P/E of 20.5x, which is lower than the industry average of 45.4x. While ATV 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Acorn International
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 ATV
Price per share = $18.62
Earnings per share = $0.91
∴ Price-Earnings Ratio = $18.62 ÷ $0.91 = 20.5x
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 ATV, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. 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.
Since ATV’s P/E of 20.5x is lower than its industry peers (45.4x), it means that investors are paying less than they should for each dollar of ATV’s earnings. As such, our analysis shows that ATV represents an under-priced stock.
A few caveats
Before you jump to the conclusion that ATV 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 ATV. 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 ATV, then investors would naturally value ATV at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with ATV, investors would also value ATV at a lower price since it is a lower growth investment. Both scenarios would explain why ATV has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing ATV to are fairly valued by the market. If this assumption is violated, ATV’s P/E may be lower than its peers because its peers are actually overvalued 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 add more of ATV to your portfolio. 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:
- Financial Health: Is ATV’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 ATV 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 ATV’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.