FFI Holdings Limited (ASX:FFI) is trading with a trailing P/E of 17.8x, which is higher than the industry average of 12.3x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for FFI Holdings
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 FFI
Price-Earnings Ratio = Price per share ÷ Earnings per share
FFI Price-Earnings Ratio = 3.85 ÷ 0.217 = 17.8x
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 FFI, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 17.8x, FFI’s P/E is higher than its industry peers (12.3x). This implies that investors are overvaluing each dollar of FFI’s earnings. Therefore, according to this analysis, FFI is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your FFI 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 FFI, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with FFI, 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 FFI to are fairly valued by the market. If this is violated, FFI'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? 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 FFI. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.