Lancaster Colony Corporation (NASDAQ:LANC) trades with a trailing P/E of 28.6x, which is higher than the industry average of 26.7x. While this makes LANC 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. Check out our latest analysis for Lancaster Colony

Demystifying 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 LANC

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

LANC Price-Earnings Ratio = 120.28 ÷ 4.205 = 28.6x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 LANC, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since LANC's P/E of 28.6x is higher than its industry peers (26.7x), it means that investors are paying more than they should for each dollar of LANC's earnings. Therefore, according to this analysis, LANC is an over-priced stock.

Assumptions to be aware of

However, before you rush out to sell your LANC shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to LANC, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with LANC, 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 LANC to are fairly valued by the market. If this does not hold, there is a possibility that LANC’s P/E is lower because our peer group is 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 LANC. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.