This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between New Hope Corporation Limited (ASX:NHC)’s fundamentals and stock market performance.
New Hope Corporation Limited (ASX:NHC) is currently trading at a trailing P/E of 13.4x, which is higher than the industry average of 10.6x. While NHC 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 explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for New Hope
Breaking down 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 NHC
Price-Earnings Ratio = Price per share ÷ Earnings per share
NHC Price-Earnings Ratio = A$3.03 ÷ A$0.226 = 13.4x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to NHC, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 13.4x, NHC’s P/E is higher than its industry peers (10.6x). This implies that investors are overvaluing each dollar of NHC’s earnings. As such, our analysis shows that NHC represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that NHC should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to NHC, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with NHC, 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 NHC to are fairly valued by the market. If this does not hold, there is a possibility that NHC’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
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 NHC. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following: