Peel Hotels plc (AIM:PHO) is trading with a trailing P/E of 61.7x, which is higher than the industry average of 21.7x. While PHO 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Peel Hotels
What you need to know about the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 pound of the company’s earnings.
P/E Calculation for PHO
Price-Earnings Ratio = Price per share ÷ Earnings per share
PHO Price-Earnings Ratio = £0.95 ÷ £0.015 = 61.7x
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 PHO, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since PHO’s P/E of 61.7x is higher than its industry peers (21.7x), it means that investors are paying more than they should for each dollar of PHO’s earnings. As such, our analysis shows that PHO represents an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that PHO 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 PHO, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with PHO, 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 PHO to are fairly valued by the market. If this does not hold, there is a possibility that PHO’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on PHO, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above.