PWR Holdings Limited (ASX:PWH) is currently trading at a trailing P/E of 28x, which is higher than the industry average of 15x. While this makes PWH 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for PWH
Breaking down 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 PWH
Price-Earnings Ratio = Price per share ÷ Earnings per share
PWH Price-Earnings Ratio = 2.6 ÷ 0.093 = 28x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to PWH, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since PWH’s P/E of 28x is higher than its industry peers (15x), it means that investors are paying more than they should for each dollar of PWH’s earnings. As such, our analysis shows that PWH represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that PWH should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to PWH, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with PWH, 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 PWH to are fairly valued by the market. If this does not hold true, PWH’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? Since you may have already conducted your due diligence on PWH, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above.
Are you a potential investor? If you are considering investing in PWH, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.