In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
West Wits Mining Limited (ASX:WWI) trades with a trailing P/E of 13, which is higher than the industry average of 11.3. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
View our latest analysis for West Wits Mining
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 WWI
Price-Earnings Ratio = Price per share ÷ Earnings per share
WWI Price-Earnings Ratio = A$0.013 ÷ A$0.000997 = 13x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as WWI, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since WWI’s P/E of 13 is higher than its industry peers (11.3), it means that investors are paying more for each dollar of WWI’s earnings. This multiple is a median of profitable companies of 25 Metals and Mining companies in AU including Gladiator Resources, Aeris Resources and Citigold. You could also say that the market is suggesting that WWI is a stronger business than the average comparable company.
Assumptions to watch out for
However, it is important to note that our examination of the stock is based on certain assumptions. The first is that our “similar companies” are actually similar to WWI. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where West Wits Mining 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 WWI are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
What this means for you:
Since you may have already conducted your due diligence on WWI, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. 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 urge you to complete your research by taking a look at the following: