I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Northgate plc (LON:NTG) is currently trading at a trailing P/E of 12.8, which is close to the industry average of 12.8. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
View our latest analysis for Northgate
Demystifying the P/E ratio
P/E is a popular ratio used for 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 NTG
Price-Earnings Ratio = Price per share ÷ Earnings per share
NTG Price-Earnings Ratio = £4.16 ÷ £0.324 = 12.8x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to NTG, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Northgate plc (LON:NTG) trades on a trailing P/E of 12.8. This isn’t too far from the industry average (which is 12.8). This multiple is a median of profitable companies of 6 Transportation companies in GB including Go-Ahead Group, Rotala and Stagecoach Group. One could put it like this: the market is pricing NTG as if it is roughly average for its industry.
A few caveats
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to NTG. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where Northgate plc is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with NTG are not fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.
What this means for you:
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 NTG. 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. 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: