ASOS Plc (AIM:ASC) trades with a trailing P/E of 88.6x, which is higher than the industry average of 69x. While ASC 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. Check out our latest analysis for ASOS
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each pound of the company’s earnings.
P/E Calculation for ASC
Price-Earnings Ratio = Price per share ÷ Earnings per share
ASC Price-Earnings Ratio = £68.39 ÷ £0.772 = 88.6x
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 ASC, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. At 88.6x, ASC’s P/E is higher than its industry peers (69x). This implies that investors are overvaluing each dollar of ASC’s earnings. As such, our analysis shows that ASC represents an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your ASC 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 ASC. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with ASC, 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 ASC to are fairly valued by the market. If this does not hold true, ASC’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on ASC, 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.
Are you a potential investor? If ASC has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.