This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Primo Water Corporation (NASDAQ:PRMW) is trading with a trailing P/E of 58.6, which is higher than the industry average of 28.5. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Check out our latest analysis for Primo Water
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. 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 PRMW
Price-Earnings Ratio = Price per share ÷ Earnings per share
PRMW Price-Earnings Ratio = $16.57 ÷ $0.283 = 58.6x
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 PRMW, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 58.6, PRMW’s P/E is higher than its industry peers (28.5). This implies that investors are overvaluing each dollar of PRMW’s earnings. This multiple is a median of profitable companies of 16 Beverage companies in US including Keurig Dr Pepper, China New Borun and Truett-Hurst. You could also say that the market is suggesting that PRMW is a stronger business than the average comparable company.
A few caveats
However, it is important to note that our examination of the stock is based on certain assumptions. The first is that our “similar companies” are actually similar to PRMW. If not, the difference in P/E might be a result of other factors. For example, Primo Water Corporation could be growing more quickly than the companies we’re comparing it with. In that case it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with PRMW are not fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in PRMW. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. 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 highly recommend you to complete your research by taking a look at the following: