Aritzia Inc (TSX:ATZ) is trading with a trailing P/E of 26.2x, which is lower than the industry average of 28.8x. While ATZ might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, 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 Aritzia

What you need to know about the P/E ratio

The P/E ratio is one of many ratios used in relative valuation. 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 ATZ

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

ATZ Price-Earnings Ratio = CA$12.67 ÷ CA$0.483 = 26.2x

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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ATZ, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 26.2x, ATZ’s P/E is lower than its industry peers (28.8x). This implies that investors are undervaluing each dollar of ATZ’s earnings. Therefore, according to this analysis, ATZ is an under-priced stock.

A few caveats

Before you jump to the conclusion that ATZ is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to ATZ. 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 ATZ, 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 ATZ to are fairly valued by the market. If this does not hold, there is a possibility that ATZ’s P/E is lower because our peer group is overvalued by the market.

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.