Under Armour Inc (NYSE:UAA) trades with a trailing P/E of 33.5x, which is higher than the industry average of 19.9x. While UAA 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. See our latest analysis for UAA

Breaking down the P/E ratio

P/E is often used for relative valuation since earnings power is a chief 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 UAA

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

UAA Price-Earnings Ratio = 16.53 ÷ 0.494 = 33.5x

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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as UAA, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. UAA’s P/E of 33.5x is higher than its industry peers (19.9x), which implies that each dollar of UAA’s earnings is being overvalued by investors. As such, our analysis shows that UAA represents an over-priced stock.

A few caveats

Before you jump to the conclusion that UAA 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 UAA. 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 UAA, 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 UAA to are fairly valued by the market. If this does not hold true, UAA’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 UAA, 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 UAA 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.