This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.
Olam International Limited (SGX:O32) is trading with a trailing P/E of 12x, which is lower than the industry average of 20.2x. 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 explain what the P/E ratio is as well as what you should look out for when using it.
See our latest analysis for Olam International
Breaking down the P/E ratio
P/E is a popular ratio used for relative valuation. 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 O32
Price-Earnings Ratio = Price per share ÷ Earnings per share
O32 Price-Earnings Ratio = SGD2.2 ÷ SGD0.184 = 12x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to O32, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 12x, O32’s P/E is lower than its industry peers (20.1x). This implies that investors are undervaluing each dollar of O32’s earnings. Since the Consumer Retailing sector in SG is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as Sheng Siong Group, Khong Guan and . Therefore, according to this analysis, O32 is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that O32 is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to O32, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with O32, 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 O32 to are fairly valued by the market. If this is violated, O32’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 O32. 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: