Höegh LNG Holdings Ltd (OB:HLNG) is currently trading at a trailing P/E of 23.4x, which is higher than the industry average of 13.3x. While HLNG 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 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 Höegh LNG Holdings

Breaking down the Price-Earnings ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 dollar of the company’s earnings.

P/E Calculation for HLNG

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

HLNG Price-Earnings Ratio = $5.63 ÷ $0.24 = 23.4x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to HLNG, 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. Since HLNG’s P/E of 23.4x is higher than its industry peers (13.3x), it means that investors are paying more than they should for each dollar of HLNG’s earnings. As such, our analysis shows that HLNG represents an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your HLNG shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to HLNG, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with HLNG, 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 HLNG to are fairly valued by the market. If this is violated, HLNG’s P/E may be lower than its peers as they are actually overvalued by investors.

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.