Vealls Limited (ASX:VELCP) is currently trading at a trailing P/E of 156.4x, which is higher than the industry average of 21.6x. While VELCP 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. See our latest analysis for VELCP
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 VELCP
Price-Earnings Ratio = Price per share ÷ Earnings per share
VELCP Price-Earnings Ratio = 11.58 ÷ 0.074 = 156.4x
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 VELCP, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 156.4x, VELCP’s P/E is higher than its industry peers (21.6x). This implies that investors are overvaluing each dollar of VELCP’s earnings. Therefore, according to this analysis, VELCP is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your VELCP shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to VELCP. 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 VELCP, 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 VELCP to are fairly valued by the market. If this does not hold true, VELCP’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? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in VELCP. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.