Aggreko plc (LSE:AGK) trades with a trailing P/E of 16.9x, which is higher than the industry average of 13.6x. While this makes AGK 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. 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 Aggreko

Demystifying the P/E 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 pound of the company’s earnings.

P/E Calculation for AGK

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

AGK Price-Earnings Ratio = £7.99 ÷ £0.472 = 16.9x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to AGK, 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. Since AGK’s P/E of 16.9x is higher than its industry peers (13.6x), it means that investors are paying more than they should for each dollar of AGK’s earnings. Therefore, according to this analysis, AGK is an over-priced stock.

Assumptions to be aware of

However, before you rush out to sell your AGK 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 AGK. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with AGK, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing AGK to are fairly valued by the market. If this does not hold true, AGK’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 AGK, 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 AGK has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.