Medibank Private Limited (ASX:MPL) is currently trading at a trailing P/E of 18.1x, which is higher than the industry average of 16.4x. While MPL 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. 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 Medibank Private

Breaking down the Price-Earnings ratio

P/E is a popular ratio used for relative valuation. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for MPL

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

MPL Price-Earnings Ratio = 2.95 ÷ 0.163 = 18.1x

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 MPL, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. MPL’s P/E of 18.1x is higher than its industry peers (16.4x), which implies that each dollar of MPL’s earnings is being overvalued by investors. As such, our analysis shows that MPL represents an over-priced stock.

A few caveats

However, before you rush out to sell your MPL 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 MPL. 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 MPL, 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 MPL to are fairly valued by the market. If this does not hold true, MPL’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? Since you may have already conducted your due diligence on MPL, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.

Are you a potential investor? If MPL has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Medibank Private for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

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.