In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
N4 Pharma Plc (LON:N4P) trades with a trailing P/E of 60.8, which is higher than the industry average of 39. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Check out our latest analysis for N4 Pharma
Demystifying 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 N4P
Price-Earnings Ratio = Price per share ÷ Earnings per share
N4P Price-Earnings Ratio = £0.048 ÷ £0.000781 = 60.8x
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 N4P, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. N4P’s P/E of 60.8 is higher than its industry peers (39), which implies that each dollar of N4P’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 8 Pharmaceuticals companies in GB including Redx Pharma, Alliance Pharma and ECO Animal Health Group. You could also say that the market is suggesting that N4P is a stronger business than the average comparable company.
Assumptions to watch out for
However, it is important to note that our examination of the stock is based on certain assumptions. The first is that our “similar companies” are actually similar to N4P. If not, the difference in P/E might be a result of other factors. For example, if N4 Pharma Plc is growing faster than its peers, then it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to N4P may not be fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.
What this means for you:
Since you may have already conducted your due diligence on N4P, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. 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: