Northern Star Resources Limited (ASX:NST) trades with a trailing P/E of 16.5x, which is higher than the industry average of 13.9x. 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. Check out our latest analysis for Northern Star Resources

Breaking down the Price-Earnings ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 NST

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

NST Price-Earnings Ratio = 5.2 ÷ 0.315 = 16.5x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 NST, 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. At 16.5x, NST’s P/E is higher than its industry peers (13.9x). This implies that investors are overvaluing each dollar of NST’s earnings. As such, our analysis shows that NST represents an over-priced stock.

A few caveats

However, before you rush out to sell your NST 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 NST, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with NST, 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 NST to are fairly valued by the market. If this does not hold true, NST’s lower P/E ratio may be because firms in our peer group are expensive 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 NST. 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.