Bridgepoint Education Inc (NYSE:BPI) is trading with a trailing P/E of 21.4x, which is higher than the industry average of 20.3x. While BPI 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 explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Bridgepoint Education

Demystifying the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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 BPI

Price-Earnings Ratio = Price per share ÷ Earnings per share

BPI Price-Earnings Ratio = $7.05 ÷ $0.329 = 21.4x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as BPI, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. BPI’s P/E of 21.4x is higher than its industry peers (20.3x), which implies that each dollar of BPI’s earnings is being overvalued by investors. Therefore, according to this analysis, BPI is an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your BPI shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to BPI. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with BPI, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing BPI to are fairly valued by the market. If this does not hold, there is a possibility that BPI’s P/E is lower because our peer group is overvalued by the market.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.