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This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Northern Star Resources Limited (ASX:NST) trades with a trailing P/E of 27.7, which is higher than the industry average of 9.6. Though this might seem to be a negative, 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.
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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. 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 NST
Price-Earnings Ratio = Price per share ÷ Earnings per share
NST Price-Earnings Ratio = A$8.91 ÷ A$0.321 = 27.7x
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 NST, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 27.7, NST’s P/E is higher than its industry peers (9.6). This implies that investors are overvaluing each dollar of NST’s earnings. This multiple is a median of profitable companies of 25 Metals and Mining companies in AU including Aeris Resources, Citigold and Highlands Pacific. You could think of it like this: the market is pricing NST as if it is a stronger company than the average of its industry group.
A few caveats
However, it is important to note that our examination of the stock is based on certain assumptions. Firstly, that our peer group contains companies that are similar to NST. If this isn’t the case, the difference in P/E could be due to other factors. Take, for example, the scenario where Northern Star Resources Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with NST are not fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.