Navigator Global Investments Limited (ASX:NGI) is trading with a trailing P/E of 27.8x, which is higher than the industry average of 23.4x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. 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 Navigator Global Investments

Breaking down the Price-Earnings ratio

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

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

NGI Price-Earnings Ratio = $3.04 ÷ $0.109 = 27.8x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to NGI, 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. At 27.8x, NGI’s P/E is higher than its industry peers (23.4x). This implies that investors are overvaluing each dollar of NGI’s earnings. As such, our analysis shows that NGI represents an over-priced stock.

Assumptions to watch out for

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