Redrow plc (LSE:RDW) is trading with a trailing P/E of 7.9x, which is lower than the industry average of 11.9x. While RDW 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. 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 Redrow
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 RDW
Price-Earnings Ratio = Price per share ÷ Earnings per share
RDW Price-Earnings Ratio = £6.25 ÷ £0.788 = 7.9x
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 RDW, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 7.9x, RDW’s P/E is lower than its industry peers (11.9x). This implies that investors are undervaluing each dollar of RDW’s earnings. As such, our analysis shows that RDW represents an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that RDW is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to RDW. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with RDW, 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 RDW to are fairly valued by the market. If this does not hold, there is a possibility that RDW’s P/E is lower because our peer group is overvalued by the market.
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 RDW. 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 urge you to complete your research by taking a look at the following: