Demystifying the P / E relationship
A common ratio used for the relative valuation is the P / E ratio. Compare the price per share of an action with the earnings per share of the share. A more intuitive way to understand the P / E relationship is to think about how much investors pay for each dollar of the company's profits.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for VIL
Price per share = NZ$0.05
Earnings per share = NZ$0.094
∴ Price-Earnings Ratio = NZ$0.05 ÷ NZ$0.094 = 0.5x
The P / E ratio is not a metric that you see in isolation and only becomes useful when you compare it with other similar companies. In short, our objective is to compare the P / E ratio of the shares with the average of companies that have similar attributes to VIL, such as the useful life of the company and the products sold. A quick method to create a peer group is to use companies in the same industry, which is what I will do. Since similar companies are expected to have similar P / E ratios, we can reach some conclusions about the stock if the proportions are different.
With 0.5x, the VIL P / E is lower than that of its industry peers (20.9x). This implies that investors are underestimating every dollar of VIL earnings. Therefore, according to this analysis, VIL is a stock at a low price.
However, before rushing to buy VIL, it is important to keep in mind that this conclusion is based on two key assumptions. The first is that our "similar companies" are actually similar to VIL. If the companies are not similar, the difference in P / E could be the result of other factors. For example, if you inadvertently compare lower risk companies with VIL, then the VIL P / E would, of course, be lower than that of its peers, since investors would value those with lower risk at a higher price. The other possibility is if you accidentally compare higher growth companies with VIL. In this case, the VIL P / E would be lower since investors would also reward the higher growth of their peers with a higher price. The second assumption that must be true is that the actions with which we are comparing VIL are justly valued by the market. If this is not fulfilled, there is a possibility that the VIL P / E is lower because the market is overvaluing the companies in our peer group.
What this means for you:
It is possible that you have already carried out a fundamental analysis of the shares as a shareholder, so your current undervaluation could indicate a good purchase opportunity to increase your exposure to VIL. Now that you understand the details of the PE metric, you must know how to take into account its limitations before making an investment decision. Remember that basing your investment decision on a single metric alone is not enough. There are many things that I have not taken into account in this article and the proportion of PE is very one-dimensional. If you have not already done so, I recommend that you complete your research take a look at the following:
1. Financial health: Are VIL operations financially sustainable? Balances can be difficult to analyze, and that is why we have done it for you. See our financial health controls here.
2. Previous history: has VIL had a constant performance regardless of the ups and downs of the market? Enter more details in the past performance analysis and take a look at the free visual representations of the VIL records for clarity.
3. Other high-performance actions: are there other actions that provide better prospects with a proven track record? Explore our free list of these excellent actions here.