In This Article:
I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
NZX Limited (NZSE:NZX) trades with a trailing P/E of 16.6, which is higher than the industry average of 15.6. While this might not seem positive, 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.
Check out our latest analysis for NZX
Breaking down the P/E 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 NZX
Price-Earnings Ratio = Price per share ÷ Earnings per share
NZX Price-Earnings Ratio = NZ$1.08 ÷ NZ$0.0650 = 16.6x
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 NZX, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. NZX’s P/E of 16.6 is higher than its industry peers (15.6), which implies that each dollar of NZX’s earnings is being overvalued by investors. Since the Capital Markets sector in NZ is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as Pyne Gould, Marlin Global and . You could think of it like this: the market is pricing NZX as if it is a stronger company than the average of its industry group.
A few caveats
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. Firstly, that our peer group contains companies that are similar to NZX. If this isn’t the case, the difference in P/E could be due to other factors. Take, for example, the scenario where NZX Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with NZX are not 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.