Alumina Limited (ASX:AWC) is trading with a trailing P/E of 15.3x, which is higher than the industry average of 14x. While AWC might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Alumina
What you need to know about the P/E ratio
P/E is a popular ratio used for 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 dollar of the company’s earnings.
P/E Calculation for AWC
Price-Earnings Ratio = Price per share ÷ Earnings per share
AWC Price-Earnings Ratio = $1.81 ÷ $0.118 = 15.3x
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 AWC, 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. Since AWC’s P/E of 15.3x is higher than its industry peers (14x), it means that investors are paying more than they should for each dollar of AWC’s earnings. As such, our analysis shows that AWC represents an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your AWC shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to AWC. 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 AWC, 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 AWC to are fairly valued by the market. If this does not hold, there is a possibility that AWC’s P/E is lower because our peer group is overvalued by the market.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.