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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
MotorCycle Holdings Limited (ASX:MTO) is currently trading at a trailing P/E of 19.7, which is higher than the industry average of 14.2. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, 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 MotorCycle Holdings
Demystifying the P/E 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 dollar of the company’s earnings.
P/E Calculation for MTO
Price-Earnings Ratio = Price per share ÷ Earnings per share
MTO Price-Earnings Ratio = A$3.28 ÷ A$0.166 = 19.7x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to MTO, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since MTO’s P/E of 19.7 is higher than its industry peers (14.2), it means that investors are paying more for each dollar of MTO’s earnings. This multiple is a median of profitable companies of 24 Specialty Retail companies in AU including Sunbridge Group, Story-I and Cash Converters International. You could think of it like this: the market is pricing MTO as if it is a stronger company than the average of its industry group.
A few caveats
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. Firstly, that our peer group contains companies that are similar to MTO. If this isn’t the case, the difference in P/E could be due to other factors. For example, if MotorCycle Holdings Limited is growing faster than its peers, then it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with MTO are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.