Konekt Limited (ASX:KKT) is trading with a trailing P/E of 9.8x, which is lower than the industry average of 23.9x. 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. Check out our latest analysis for Konekt
What you need to know about 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.
P/E Calculation for KKT
Price-Earnings Ratio = Price per share ÷ Earnings per share
KKT Price-Earnings Ratio = A$0.48 ÷ A$0.049 = 9.8x
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 KKT, 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. KKT’s P/E of 9.8x is lower than its industry peers (23.9x), which implies that each dollar of KKT’s earnings is being undervalued by investors. As such, our analysis shows that KKT represents an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy KKT immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to KKT. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with KKT, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing KKT to are fairly valued by the market. If this does not hold, there is a possibility that KKT’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? 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 KKT 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.
Are you a potential investor? If you are considering investing in KKT, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.