Pinnacle Investment Management Group Limited (ASX:PNI) is currently trading at a trailing P/E of 46.1x, which is higher than the industry average of 22.2x. 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. See our latest analysis for Pinnacle Investment Management Group
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 PNI
Price-Earnings Ratio = Price per share ÷ Earnings per share
PNI Price-Earnings Ratio = A$3.75 ÷ A$0.081 = 46.1x
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 PNI, 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. At 46.1x, PNI’s P/E is higher than its industry peers (22.2x). This implies that investors are overvaluing each dollar of PNI’s earnings. As such, our analysis shows that PNI represents an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your PNI shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to PNI, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with PNI, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing PNI to are fairly valued by the market. If this is violated, PNI’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? 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 PNI. 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.