Diversified United Investment Limited (ASX:DUI) is trading with a trailing P/E of 24.2x, which is higher than the industry average of 21.7x. While DUI 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for DUI

Breaking down the Price-Earnings ratio

A common ratio used for relative valuation is the P/E ratio. 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 DUI

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

DUI Price-Earnings Ratio = 3.82 ÷ 0.158 = 24.2x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to DUI, 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 24.2x, DUI’s P/E is higher than its industry peers (21.7x). This implies that investors are overvaluing each dollar of DUI’s earnings. Therefore, according to this analysis, DUI is an over-priced stock.

Assumptions to be aware of

However, before you rush out to sell your DUI shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to DUI. 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 DUI, 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 DUI to are fairly valued by the market. If this does not hold, there is a possibility that DUI’s P/E is lower because our peer group is overvalued by the market.

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 DUI. 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.