North American Construction Group Ltd (NYSE:NOA) trades with a trailing P/E of 31.6x, which is higher than the industry average of 18.1x. While NOA 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for North American Construction Group

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 NOA

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

NOA Price-Earnings Ratio = CA$8.24 ÷ CA$0.261 = 31.6x

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 NOA, 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. NOA’s P/E of 31.6x is higher than its industry peers (18.1x), which implies that each dollar of NOA’s earnings is being overvalued by investors. As such, our analysis shows that NOA represents an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your NOA shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to NOA, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with NOA, 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 NOA to are fairly valued by the market. If this does not hold true, NOA’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

Since you may have already conducted your due diligence on NOA, 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 highly recommend you to complete your research by taking a look at the following:

1. Future Outlook: What are well-informed industry analysts predicting for NOA’s future growth? Take a look at our free research report of analyst consensus for NOA’s outlook.

2. Past Track Record: Has NOA been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of NOA’s historicals for more clarity.

3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.