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.