Reece Limited (ASX:REH) trades with a trailing P/E of 21.1x, which is higher than the industry average of 12.4x. 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. Check out our latest analysis for Reece

Demystifying the P/E ratio

The P/E ratio is one of many ratios used in 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 REH

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

REH Price-Earnings Ratio = 44.77 ÷ 2.126 = 21.1x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to REH, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. REH’s P/E of 21.1x is higher than its industry peers (12.4x), which implies that each dollar of REH’s earnings is being overvalued by investors. As such, our analysis shows that REH represents an over-priced stock.

A few caveats

Before you jump to the conclusion that REH should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to REH. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with REH, 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 REH to are fairly valued by the market. If this is violated, REH’s P/E may be lower than its peers as they are actually overvalued by investors.

What this means for you:

Are you a shareholder? Since you may have already conducted your due diligence on REH, 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 you are considering investing in REH, 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.