ALS Limited (ASX:ALQ) is trading with a trailing P/E of 42.4x, which is higher than the industry average of 19.6x. While ALQ 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 explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for ALS

What you need to know about 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 ALQ

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

ALQ Price-Earnings Ratio = 8.19 ÷ 0.193 = 42.4x

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 ALQ, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. ALQ’s P/E of 42.4x is higher than its industry peers (19.6x), which implies that each dollar of ALQ’s earnings is being overvalued by investors. Therefore, according to this analysis, ALQ is an over-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that ALQ 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 ALQ. 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 ALQ, 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 ALQ to are fairly valued by the market. If this does not hold true, ALQ’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

Are you a shareholder? 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 ALQ. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.