In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between Merchant House International Limited (ASX:MHI)’s fundamentals and stock market performance.
Merchant House International Limited (ASX:MHI) is currently trading at a trailing P/E of 25.5x, which is higher than the industry average of 19.1x. While MHI 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. View out our latest analysis for Merchant House International
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 MHI
Price-Earnings Ratio = Price per share ÷ Earnings per share
MHI Price-Earnings Ratio = A$0.17 ÷ A$0.00648 = 25.5x
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 MHI, 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. MHI’s P/E of 25.5x is higher than its industry peers (19.1x), which implies that each dollar of MHI’s earnings is being overvalued by investors. As such, our analysis shows that MHI represents an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your MHI shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to MHI. 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 MHI, 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 MHI to are fairly valued by the market. If this does not hold, there is a possibility that MHI’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on MHI, 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. 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 urge you to complete your research by taking a look at the following: