Kip McGrath Education Centres Limited (ASX:KME) trades with a trailing P/E of 16.7x, which is higher than the industry average of 15.6x. While KME 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Kip McGrath Education Centres

Demystifying the P/E ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 KME

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

KME Price-Earnings Ratio = A$0.55 ÷ A$0.033 = 16.7x

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 KME, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since KME’s P/E of 16.7x is higher than its industry peers (15.6x), it means that investors are paying more than they should for each dollar of KME’s earnings. Therefore, according to this analysis, KME is an over-priced stock.

A few caveats

Before you jump to the conclusion that KME 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 KME, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with KME, 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 KME to are fairly valued by the market. If this does not hold true, KME’s lower P/E ratio may be because firms in our peer group are 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.