RYB Education Inc (NYSE:RYB) trades with a trailing P/E of 84.5x, which is higher than the industry average of 24.6x. While this makes RYB appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for RYB

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief 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 RYB

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

RYB Price-Earnings Ratio = $27.81 ÷ $0.329 = 84.5x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as RYB, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since RYB’s P/E of 84.5x is higher than its industry peers (24.6x), it means that investors are paying more than they should for each dollar of RYB’s earnings. As such, our analysis shows that RYB represents an over-priced stock.

A few caveats

Before you jump to the conclusion that RYB should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to RYB. 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 RYB, 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 RYB to are fairly valued by the market. If this does not hold true, RYB’s lower P/E ratio may be because firms in our peer group are 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 overvaluation could signal a potential selling opportunity to reduce your exposure to RYB. 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.