Alamo Group Inc (NYSE:ALG) trades with a trailing P/E of 26.5x, which is higher than the industry average of 23.9x. While this makes ALG appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. 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 Alamo Group
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 ALG
Price-Earnings Ratio = Price per share ÷ Earnings per share
ALG Price-Earnings Ratio = $111.84 ÷ $4.225 = 26.5x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ALG, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. ALG’s P/E of 26.5x is higher than its industry peers (23.9x), which implies that each dollar of ALG’s earnings is being overvalued by investors. As such, our analysis shows that ALG represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your ALG shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to ALG. 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 ALG, 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 ALG to are fairly valued by the market. If this does not hold true, ALG’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 ALG. 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 you are considering investing in ALG, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.