Alleghany Corporation (NYSE:Y) trades with a trailing P/E of 81.2x, which is higher than the industry average of 14.3x. While this makes Y 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Alleghany
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. 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 Y
Price-Earnings Ratio = Price per share ÷ Earnings per share
Y Price-Earnings Ratio = $593.01 ÷ $7.305 = 81.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 Y, 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 81.2x, Y’s P/E is higher than its industry peers (14.3x). This implies that investors are overvaluing each dollar of Y’s earnings. As such, our analysis shows that Y represents an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your Y 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 Y. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with Y, 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 Y to are fairly valued by the market. If this is violated, Y’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to Y. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following: