Memtech International Ltd (SGX:BOL) is trading with a trailing P/E of 9.4x, which is lower than the industry average of 9.6x. While BOL 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. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Memtech International
Breaking down 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 BOL
Price-Earnings Ratio = Price per share ÷ Earnings per share
BOL Price-Earnings Ratio = $0.93 ÷ $0.098 = 9.4x
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 BOL, 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. BOL’s P/E of 9.4x is lower than its industry peers (9.6x), which implies that each dollar of BOL’s earnings is being undervalued by investors. Therefore, according to this analysis, BOL is an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy BOL, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to BOL, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with BOL, 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 BOL to are fairly valued by the market. If this is violated, BOL’s P/E may be lower than its peers as they 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 BOL. 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: