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Argo Investments Limited (ASX:ARG) is trading with a trailing P/E of 24.9x, which is higher than the industry average of 18.7x. While ARG might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Argo Investments
What you need to know about the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 ARG
Price-Earnings Ratio = Price per share ÷ Earnings per share
ARG Price-Earnings Ratio = A$7.83 ÷ A$0.314 = 24.9x
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 ARG, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 24.9x, ARG’s P/E is higher than its industry peers (18.7x). This implies that investors are overvaluing each dollar of ARG’s earnings. As such, our analysis shows that ARG represents an over-priced stock.
A few caveats
Before you jump to the conclusion that ARG should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to ARG, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with ARG, 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 ARG to are fairly valued by the market. If this is violated, ARG’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 ARG. 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: