Nick Scali Limited (ASX:NCK) is trading with a trailing P/E of 14.1x, which is lower than the industry average of 14.6x. While this makes NCK appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Nick Scali
Breaking down the Price-Earnings 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 NCK
Price-Earnings Ratio = Price per share ÷ Earnings per share
NCK Price-Earnings Ratio = 6.5 ÷ 0.46 = 14.1x
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 NCK, 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. Since NCK's P/E of 14.1x is lower than its industry peers (14.6x), it means that investors are paying less than they should for each dollar of NCK's earnings. Therefore, according to this analysis, NCK is an under-priced stock.
A few caveats
While our conclusion might prompt you to buy NCK immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to NCK. 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 NCK, 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 NCK to are fairly valued by the market. If this is violated, NCK'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 undervaluation could signal a good buying opportunity to increase your exposure to NCK. 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.