ASX Limited (ASX:ASX) trades with a trailing P/E of 23.5x, which is higher than the industry average of 21.7x. While ASX 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for ASX

What you need to know about the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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 ASX

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

ASX Price-Earnings Ratio = 52.64 ÷ 2.244 = 23.5x

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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ASX, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. ASX’s P/E of 23.5x is higher than its industry peers (21.7x), which implies that each dollar of ASX’s earnings is being overvalued by investors. Therefore, according to this analysis, ASX is an over-priced stock.

A few caveats

Before you jump to the conclusion that ASX 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 ASX. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with ASX, 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 ASX to are fairly valued by the market. If this does not hold, there is a possibility that ASX’s P/E is lower because our peer group is 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 ASX. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.

Are you a potential investor? If you are considering investing in ASX, 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.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on ASX for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.