Nova Measuring Instruments Ltd (NASDAQ:NVMI) trades with a trailing P/E of 15.6x, which is lower than the industry average of 24.6x. While NVMI might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 Nova Measuring Instruments

Breaking down the Price-Earnings ratio

P/E is often used for relative valuation since earnings power is a chief 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 NVMI

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

NVMI Price-Earnings Ratio = $26.25 ÷ $1.677 = 15.6x

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 NVMI, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since NVMI’s P/E of 15.6x is lower than its industry peers (24.6x), it means that investors are paying less than they should for each dollar of NVMI’s earnings. As such, our analysis shows that NVMI represents an under-priced stock.

Assumptions to watch out for

However, before you rush out to buy NVMI, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to NVMI. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with NVMI, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing NVMI to are fairly valued by the market. If this does not hold, there is a possibility that NVMI’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 NVMI, the undervaluation of the stock may mean it is a good time to top up on 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: