Inmarsat Plc (LSE:ISAT) trades with a trailing P/E of 13.4x, which is lower than the industry average of 21.5x. While ISAT 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. 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 Inmarsat
Breaking down the Price-Earnings 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 pound of the company’s earnings.
P/E Calculation for ISAT
Price-Earnings Ratio = Price per share ÷ Earnings per share
ISAT Price-Earnings Ratio = $6.41 ÷ $0.479 = 13.4x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as ISAT, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since ISAT’s P/E of 13.4x is lower than its industry peers (21.5x), it means that investors are paying less than they should for each dollar of ISAT’s earnings. Therefore, according to this analysis, ISAT is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy ISAT, 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 ISAT, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with ISAT, 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 ISAT to are fairly valued by the market. If this does not hold, there is a possibility that ISAT’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on ISAT, the undervaluation of the stock may mean it is a good time to top up on 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.
Are you a potential investor? If ISAT has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.