The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 DAF

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

DAF Price-Earnings Ratio = 0.01 ÷ 0.002 = 5.8x

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 DAF, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. DAF’s P/E of 5.8x is lower than its industry peers (13.1x), which implies that each dollar of DAF’s earnings is being undervalued by investors. Therefore, according to this analysis, DAF is an under-priced stock.

A few caveats

However, before you rush out to buy DAF, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to DAF. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with DAF, 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 DAF to are fairly valued by the market. If this does not hold, there is a possibility that DAF’s P/E is lower because our peer group is overvalued by the market.

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 DAF. 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 DAF, 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 Discovery Africa 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.

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.