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Ridley Corporation Limited (ASX:RIC) is trading with a trailing P/E of 17.2x, which is higher than the industry average of 15.5x. While RIC might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Ridley
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in 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 RIC
Price-Earnings Ratio = Price per share ÷ Earnings per share
RIC Price-Earnings Ratio = A$1.36 ÷ A$0.079 = 17.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to RIC, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since RIC’s P/E of 17.2x is higher than its industry peers (15.5x), it means that investors are paying more than they should for each dollar of RIC’s earnings. Therefore, according to this analysis, RIC is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that RIC 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 RIC, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with RIC, 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 RIC to are fairly valued by the market. If this does not hold true, RIC’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
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 RIC. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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: