Abano Healthcare Group Limited (NZSE:ABA) trades with a trailing P/E of 20x, which is higher than the industry average of 8.8x. While ABA 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 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 Abano Healthcare Group

Breaking down the Price-Earnings ratio

P/E is a popular ratio used for relative valuation. 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 ABA

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

ABA Price-Earnings Ratio = NZ$9.75 ÷ NZ$0.488 = 20x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 ABA, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. ABA’s P/E of 20x is higher than its industry peers (8.8x), which implies that each dollar of ABA’s earnings is being overvalued by investors. Therefore, according to this analysis, ABA is an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your ABA shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to ABA, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with ABA, 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 ABA to are fairly valued by the market. If this is violated, ABA’s P/E may be lower than its peers as they are actually overvalued by investors.

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.