Netcall plc (AIM:NET) is trading with a trailing P/E of 45.5x, which is higher than the industry average of 26.3x. While NET 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. 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 Netcall
Demystifying the P/E ratio
P/E is a popular ratio used for 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 pound of the company’s earnings.
P/E Calculation for NET
Price-Earnings Ratio = Price per share ÷ Earnings per share
NET Price-Earnings Ratio = 0.48 ÷ 0.011 = 45.5x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to NET, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since NET's P/E of 45.5x is higher than its industry peers (26.3x), it means that investors are paying more than they should for each dollar of NET's earnings. Therefore, according to this analysis, NET is an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your NET shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to NET, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with NET, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing NET to are fairly valued by the market. If this is violated, NET's P/E may be lower than its peers as they are actually overvalued by investors.
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 NET. 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 NET, 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.