Joules Group Plc (AIM:JOUL) trades with a trailing P/E of 36.9x, which is higher than the industry average of 24.5x. 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. Check out our latest analysis for Joules Group

Breaking down the Price-Earnings 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 pound of the company’s earnings.

P/E Calculation for JOUL

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

JOUL Price-Earnings Ratio = £3.15 ÷ £0.085 = 36.9x

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 JOUL, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. JOUL’s P/E of 36.9x is higher than its industry peers (24.5x), which implies that each dollar of JOUL’s earnings is being overvalued by investors. Therefore, according to this analysis, JOUL is an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your JOUL shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to JOUL, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with JOUL, 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 JOUL to are fairly valued by the market. If this does not hold, there is a possibility that JOUL’s P/E is lower because our peer group is overvalued by the market.

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.