JB Hi-Fi Limited (ASX:JBH) trades with a trailing P/E of 14.8x, which is higher than the industry average of 14.6x. 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for JB Hi-Fi
Demystifying 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 JBH
Price-Earnings Ratio = Price per share ÷ Earnings per share
JBH Price-Earnings Ratio = 22.86 ÷ 1.543 = 14.8x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to JBH, 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. JBH’s P/E of 14.8x is higher than its industry peers (14.6x), which implies that each dollar of JBH’s earnings is being overvalued by investors. Therefore, according to this analysis, JBH is an over-priced stock.
A few caveats
However, before you rush out to sell your JBH 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 JBH, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with JBH, 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 JBH to are fairly valued by the market. If this does not hold, there is a possibility that JBH’s P/E is lower because our peer group is 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 JBH. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in JBH, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.