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 learn about the link between company’s fundamentals and stock market performance.
Aeorema Communications plc (LON:AEO) is currently trading at a trailing P/E of 65.9, which is higher than the industry average of 30.8. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. 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.
What you need to know about the P/E 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 dollar of the company’s earnings.
P/E Calculation for AEO
Price-Earnings Ratio = Price per share ÷ Earnings per share
AEO Price-Earnings Ratio = £0.26 ÷ £0.00394 = 65.9x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AEO, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 65.9, AEO’s P/E is higher than its industry peers (30.8). This implies that investors are overvaluing each dollar of AEO’s earnings. This multiple is a median of profitable companies of 9 Entertainment companies in GB including Team17 Group, Celtic and One Media iP Group. You could also say that the market is suggesting that AEO is a stronger business than the average comparable company.
A few caveats
However, it is important to note that our examination of the stock is based on certain assumptions. The first is that our “similar companies” are actually similar to AEO. If not, the difference in P/E might be a result of other factors. For example, if Aeorema Communications plc 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 AEO are not fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in AEO. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. 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:
- Future Outlook: What are well-informed industry analysts predicting for AEO’s future growth? Take a look at our free research report of analyst consensus for AEO’s outlook.
- Past Track Record: Has AEO been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of AEO’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past 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. For errors that warrant correction please contact the editor at firstname.lastname@example.org.