LendLease Group (ASX:LLC) is trading with a trailing P/E of 13x, which is higher than the industry average of 12.6x. 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 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 LendLease Group

Breaking down 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 LLC

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

LLC Price-Earnings Ratio = A$17.9 ÷ A$1.378 = 13x

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 LLC, 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. Since LLC’s P/E of 13x is higher than its industry peers (12.6x), it means that investors are paying more than they should for each dollar of LLC’s earnings. As such, our analysis shows that LLC represents an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your LLC shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to LLC. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with LLC, 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 LLC to are fairly valued by the market. If this is violated, LLC’s P/E may be lower than its peers as they are actually overvalued by investors.

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.