Ames National Corporation (NASDAQ:ATLO) is trading with a trailing P/E of 19.5x, which is higher than the industry average of 18.6x. 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. In this article, 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 ATLO
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 ATLO
Price-Earnings Ratio = Price per share ÷ Earnings per share
ATLO Price-Earnings Ratio = 31.25 ÷ 1.601 = 19.5x
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 ATLO, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since ATLO's P/E of 19.5x is higher than its industry peers (18.6x), it means that investors are paying more than they should for each dollar of ATLO's earnings. As such, our analysis shows that ATLO represents an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that ATLO 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 ATLO. 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 ATLO, 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 ATLO to are fairly valued by the market. If this is violated, ATLO's P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? 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 ATLO. 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.