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Saturday, 25 August 2018
Should You Sell Company ABC At This PE Ratio?

ABC is trading with a trailing P/E of 36.4x, which is higher than the industry average of 23.5x.

  • While ABC might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 
  • You should understand what the P/E ratio is, how to interpret it and what to watch out for. 

1.   Breaking down the P/E ratio

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

  • 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 ABC

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

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.

  • Your goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ABC, such as company lifetime and products sold. 
  • A quick method of creating a peer group is to use companies in the same industry
  • ABC’s P/E of 36.4x is higher than its industry peers (23.5x), which implies that each dollar of  ABC’s earnings is being overvalued by investors. Therefore, according to this analysis, ABC is an over-priced stock.

2.  Assumptions to watch out for

Before you jump to the conclusion that ABC should be banished from your portfolio, it is important to realise that your conclusion rests on two assertions. 

(a)  Firstly, your peer group contains companies that are similar to ABC.

  • If this isn’t the case, the difference in P/E could be due to other factors. 
  • For example, if you compared lower risk firms with ABC, then investors would naturally value it at a lower price since it is a riskier investment. 

(b)  The second assumption that must hold true is that the stocks we are comparing ABC to are fairly valued by the market.

  • If this is violated, ABC’s P/E may be lower than its peers as they are actually overvalued by investors.

3.   What this means for you:

(a)  Are you a shareholder? 

You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to ABC.

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.

(b)  Are you a potential investor? 

If you are considering investing in ABC, 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.

Another limitation of PE is it doesn’t properly account for growth, you can use a list of stocks with a high growth potential and see if their PE is still reasonable.

The thought process using Relative Valuation

Price based on past earnings
PE 36.4x
ABC is overvalued based one earnings compared to the industry average.
ABC is overvalued based on earnings compared to the local market.

Price based on expected growth
PEG 3.0x
ABC is poor value based on expected growth next year.

Price based on value of assets
P/B 15.3x
ABC is overvalued based on assets compared to the industry average
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