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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 U

Price-Earnings Ratio = Price per share ÷ Earnings per share

U Price-Earnings Ratio = CA$4.01 ÷ CA$0.431 = 9.3x

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 U, 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. Since U’s P/E of 9.3x is lower than its industry peers (13.6x), it means that investors are paying less than they should for each dollar of U’s earnings. Therefore, according to this analysis, U is an under-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to buy U immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to U, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with U, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing U to are fairly valued by the market. If this is violated, U’s P/E may be lower than its peers as they are actually overvalued by investors.

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.