Marlin Global Limited (NZSE:MLN) is currently trading at a trailing P/E of 6.3x, which is lower than the industry average of 18.9x. While this makes MLN appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Marlin Global
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. 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 MLN
Price-Earnings Ratio = Price per share ÷ Earnings per share
MLN Price-Earnings Ratio = NZ$0.84 ÷ NZ$0.133 = 6.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 MLN, 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. Since MLN’s P/E of 6.3x is lower than its industry peers (18.9x), it means that investors are paying less than they should for each dollar of MLN’s earnings. Therefore, according to this analysis, MLN is an under-priced stock.
A few caveats
Before you jump to the conclusion that MLN is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to MLN, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with MLN, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing MLN to are fairly valued by the market. If this does not hold true, MLN’s lower P/E ratio may be because firms in our peer group are 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 MLN 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.