The price to earnings ratio is a common metric used among analysts. It can be calculated by:
Latest transacted price per share divided by the earnings per share
If a company has a low price to earnings ratio and its growth prospects are high, then the company may be undervalued. However, if a company has a low or negative price to earnings ratio and it is projected to make losses over the next several years, the company’s PE ratio may very well be justified. In an instance like this, the company is not undervalued.
Compare PE ratio among peers
Between 2 peer companies in the same industry, with all things being equal and with growth projections to be high, the one with the lower PE ratio is generally considered undervalued.
Complement PE ratio analysis with other metrics
It is important to complement PE ratio analysis with other metrics such as the price to sale, PEG ratio, price to book value and more to arrive at a conclusion as to whether the company’s share price is undervalued or not.
A company is projected to earn $3 per share in 3 years. The price to earnings ratio of this company is between 12 times to 15 times. It’s peers in the industry trade at around the same multiples. If we apply a multiple of 12 times to $3 per share, it should trade at a price of $36 per share. The company trades at a price of $20 currently. Hence, it is considered undervalued.