RELM Wireless Corporation (AMEX:RWC) is currently trading at a trailing P/E of 59.9x, which is higher than the industry average of 29.2x. 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. 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. View our latest analysis for RELM Wireless

Breaking down the P/E ratio

A common ratio used for relative valuation is the P/E ratio. 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 RWC

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

RWC Price-Earnings Ratio = 3.75 ÷ 0.063 = 59.9x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to RWC, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. RWC’s P/E of 59.9x is higher than its industry peers (29.2x), which implies that each dollar of RWC’s earnings is being overvalued by investors. As such, our analysis shows that RWC represents an over-priced stock.

Assumptions to be aware of

However, before you rush out to sell your RWC shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to RWC, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with RWC, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing RWC to are fairly valued by the market. If this does not hold, there is a possibility that RWC’s P/E is lower because our peer group is overpriced 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 RWC. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.