Altium Limited (ASX:ALU) is trading with a trailing P/E of 63x, which is higher than the industry average of 30.2x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Altium
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 ALU
Price-Earnings Ratio = Price per share ÷ Earnings per share
ALU Price-Earnings Ratio = $16.09 ÷ $0.255 = 63x
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 ALU, 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. ALU’s P/E of 63x is higher than its industry peers (30.2x), which implies that each dollar of ALU’s earnings is being overvalued by investors. As such, our analysis shows that ALU represents an over-priced stock.
A few caveats
However, before you rush out to sell your ALU 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 ALU. 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 ALU, 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 ALU to are fairly valued by the market. If this does not hold, there is a possibility that ALU’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
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 ALU. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. 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: