IDP Education Limited (ASX:IEL) is trading with a trailing P/E of 36.4x, which is higher than the industry average of 20.6x. 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 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 IEL
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 IEL
Price-Earnings Ratio = Price per share ÷ Earnings per share
IEL Price-Earnings Ratio = 6.04 ÷ 0.166 = 36.4x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as IEL, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 36.4x, IEL’s P/E is higher than its industry peers (20.6x). This implies that investors are overvaluing each dollar of IEL’s earnings. As such, our analysis shows that IEL represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your IEL shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to IEL. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with IEL, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing IEL to are fairly valued by the market. If this is violated, IEL'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? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to IEL. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.