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Ariadne Australia Limited (ASX:ARA) is trading with a trailing P/E of 15.3x, which is lower than the industry average of 16.5x. While ARA 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 break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Ariadne Australia
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in 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.
P/E Calculation for ARA
Price-Earnings Ratio = Price per share ÷ Earnings per share
ARA Price-Earnings Ratio = A$0.76 ÷ A$0.049 = 15.3x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to ARA, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 15.3x, ARA’s P/E is lower than its industry peers (16.5x). This implies that investors are undervaluing each dollar of ARA’s earnings. As such, our analysis shows that ARA represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy ARA immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to ARA. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with ARA, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing ARA to are fairly valued by the market. If this does not hold, there is a possibility that ARA’s P/E is lower because our peer group is overvalued by the market.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.