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The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Alfa Laval AB (publ) (STO:ALFA) is currently trading at a trailing P/E of 25.9, which is higher than the industry average of 17.8. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
Check out our latest analysis for Alfa Laval
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 ALFA
Price-Earnings Ratio = Price per share ÷ Earnings per share
ALFA Price-Earnings Ratio = SEK239.7 ÷ SEK9.264 = 25.9x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to ALFA, 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 25.9, ALFA’s P/E is higher than its industry peers (17.8). This implies that investors are overvaluing each dollar of ALFA’s earnings. This multiple is a median of profitable companies of 18 Machinery companies in SE including Duroc, AB SKF and AB Volvo. You could think of it like this: the market is pricing ALFA as if it is a stronger company than the average of its industry group.
Assumptions to be aware of
However, you should be aware that this analysis makes certain assumptions. Firstly, that our peer group contains companies that are similar to ALFA. If this isn’t the case, the difference in P/E could be due to other factors. Take, for example, the scenario where Alfa Laval AB (publ) is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with ALFA are not fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.