L’Oréal SA. (ENXTPA:OR) is currently trading at a trailing P/E of 29.1x, which is higher than the industry average of 27.8x. 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 L’Oréal
Breaking down 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 OR
Price-Earnings Ratio = Price per share ÷ Earnings per share
OR Price-Earnings Ratio = €199 ÷ €6.833 = 29.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to OR, 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. OR’s P/E of 29.1x is higher than its industry peers (27.8x), which implies that each dollar of OR’s earnings is being overvalued by investors. Therefore, according to this analysis, OR is an over-priced stock.
A few caveats
Before you jump to the conclusion that OR should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to OR. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with OR, 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 OR to are fairly valued by the market. If this is violated, OR’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to OR. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 urge you to complete your research by taking a look at the following: