Daejan Holdings Plc (LSE:DJAN) is currently trading at a trailing P/E of 5.9x, which is lower than the industry average of 14x. While this makes DJAN appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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 DJAN
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for DJAN
Price per share = 58.5
Earnings per share = 9.928
∴ Price-Earnings Ratio = 58.5 ÷ 9.928 = 5.9x
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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as DJAN, 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 it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
Since DJAN’s P/E of 5.9x is lower than its industry peers (14x), it means that investors are paying less than they should for each dollar of DJAN’s earnings. Therefore, according to this analysis, DJAN is an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy DJAN, 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 DJAN. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared higher growth firms with DJAN, then DJAN’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with DJAN, DJAN’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing DJAN to are fairly valued by the market. If this assumption is violated, DJAN’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
Are you a shareholder? 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 DJAN. 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.
Are you a potential investor? If you are considering investing in DJAN, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Daejan Holdings for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
Daniel Loeb has achieved 16.2% annualized returns over the last 20 years. What is he holding today?Founder of the event-driven, value-oriented hedge fund Third Point, Daniel Loeb is one of the most successful activist investors on the market today. Explore his portfolio’s top holdings, see how he diversifies his investments, past performance and growth estimates. Click here to view a FREE detailed infographic analysis of Daniel Loeb’s investment portfolio.
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