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Livestock Improvement Corporation Limited (NZSE:LIC) is currently trading at a trailing P/E of 4.2x, which is lower than the industry average of 19.5x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Livestock Improvement
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 LIC
Price-Earnings Ratio = Price per share ÷ Earnings per share
LIC Price-Earnings Ratio = NZ$2.95 ÷ NZ$0.697 = 4.2x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to LIC, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 4.2x, LIC’s P/E is lower than its industry peers (19.5x). This implies that investors are undervaluing each dollar of LIC’s earnings. Therefore, according to this analysis, LIC is an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy LIC immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to LIC, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with LIC, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing LIC to are fairly valued by the market. If this is violated, LIC’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 LIC. 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: