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 better understand how you can grow your money by investing in Adacel Technologies Limited (ASX:ADA).
Adacel Technologies Limited (ASX:ADA) is currently trading at a trailing P/E of 15.2x, which is lower than the industry average of 29.7x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. 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. Check out our latest analysis for Adacel Technologies
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 ADA
Price-Earnings Ratio = Price per share ÷ Earnings per share
ADA Price-Earnings Ratio = A$1.74 ÷ A$0.114 = 15.2x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to ADA, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 15.2x, ADA’s P/E is lower than its industry peers (29.7x). This implies that investors are undervaluing each dollar of ADA’s earnings. Therefore, according to this analysis, ADA is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy ADA, 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 ADA, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with ADA, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing ADA to are fairly valued by the market. If this is violated, ADA’s P/E may be lower than its peers as they are actually overvalued by investors.
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 ADA. 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:
- Future Outlook: What are well-informed industry analysts predicting for ADA’s future growth? Take a look at our free research report of analyst consensus for ADA’s outlook.
- Past Track Record: Has ADA 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 ADA’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 pass 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.