MainstreamBPO Limited (ASX:MAI) trades with a trailing P/E of 30.2x, which is higher than the industry average of 21.6x. While MAI 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. Today, 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 MAI

Breaking down the Price-Earnings ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 MAI

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

MAI Price-Earnings Ratio = 0.48 ÷ 0.016 = 30.2x

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 MAI, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. MAI’s P/E of 30.2x is higher than its industry peers (21.6x), which implies that each dollar of MAI’s earnings is being overvalued by investors. Therefore, according to this analysis, MAI is an over-priced stock.

A few caveats

Before you jump to the conclusion that MAI 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 MAI. 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 MAI, 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 MAI to are fairly valued by the market. If this does not hold, there is a possibility that MAI’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in MAI. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.