Nova Measuring Instruments Ltd (NASDAQ:NVMI) trades with a trailing P/E of 25.4x, which is higher than the industry average of 24.7x. 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 explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for NVMI

What you need to know about the P/E ratio

P/E is a popular ratio used for 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 NVMI

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

NVMI Price-Earnings Ratio = 28.11 ÷ 1.106 = 25.4x

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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to NVMI, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since NVMI's P/E of 25.4x is higher than its industry peers (24.7x), it means that investors are paying more than they should for each dollar of NVMI's earnings. As such, our analysis shows that NVMI represents an over-priced stock.

Assumptions to watch out for

However, before you rush out to sell your NVMI 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 NVMI, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with NVMI, 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 NVMI to are fairly valued by the market. If this does not hold true, NVMI’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? 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 NVMI. 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 NVMI 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 Nova Measuring Instruments 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.