Seroja Investments Limited (SGX:IW5) trades with a trailing P/E of 12.2x, which is lower than the industry average of 13x. While this makes IW5 appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Seroja Investments
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 IW5
Price-Earnings Ratio = Price per share ÷ Earnings per share
IW5 Price-Earnings Ratio = $0.03 ÷ $0.003 = 12.2x
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 IW5, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. At 12.2x, IW5’s P/E is lower than its industry peers (13x). This implies that investors are undervaluing each dollar of IW5’s earnings. Therefore, according to this analysis, IW5 is an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy IW5, 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 IW5, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with IW5, 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 IW5 to are fairly valued by the market. If this does not hold true, IW5’s lower P/E ratio may be because firms in our peer group are 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 IW5. 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: