NIB Holdings Limited (ASX:NHF) is currently trading at a trailing P/E of 21.7x, which is higher than the industry average of 16.4x. While this makes NHF appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. 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. See our latest analysis for NHF
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 NHF
Price-Earnings Ratio = Price per share ÷ Earnings per share
NHF Price-Earnings Ratio = 5.9 ÷ 0.272 = 21.7x
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 NHF, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since NHF's P/E of 21.7x is higher than its industry peers (16.4x), it means that investors are paying more than they should for each dollar of NHF's earnings. As such, our analysis shows that NHF represents an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that NHF should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to NHF, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with NHF, 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 NHF to are fairly valued by the market. If this is violated, NHF'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? 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 NHF. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.