Brambles Limited (ASX:BXB) trades with a trailing P/E of 28.2x, which is higher than the industry average of 18.6x. 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 Brambles

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 BXB

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

BXB Price-Earnings Ratio = $7.9 ÷ $0.28 = 28.2x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as BXB, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since BXB’s P/E of 28.2x is higher than its industry peers (18.6x), it means that investors are paying more than they should for each dollar of BXB’s earnings. As such, our analysis shows that BXB represents an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your BXB shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to BXB. 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 BXB, 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 BXB to are fairly valued by the market. If this does not hold, there is a possibility that BXB’s P/E is lower because our peer group is overvalued by the market.

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.