In This Article:
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.
Vaudoise Assurances Holding SA (VTX:VAHN) is currently trading at a trailing P/E of 12.7x, which is lower than the industry average of 14x. While this makes VAHN appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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.
Check out our latest analysis for Vaudoise Assurances Holding
Breaking down the P/E ratio
P/E is a popular ratio used for 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 dollar of the company’s earnings.
P/E Calculation for VAHN
Price-Earnings Ratio = Price per share ÷ Earnings per share
VAHN Price-Earnings Ratio = CHF520 ÷ CHF40.992 = 12.7x
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 VAHN, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 12.7, VAHN’s P/E is lower than its industry peers (14). This implies that investors are undervaluing each dollar of VAHN’s earnings. This multiple is a median of profitable companies of 6 Insurance companies in CH including Swiss Life Holding, Bâloise Holding and Zurich Insurance Group. You can think of it like this: the market is suggesting that VAHN is a weaker business than the average comparable company.
A few caveats
However, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to VAHN, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with VAHN, 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 VAHN to are fairly valued by the market. If this does not hold, there is a possibility that VAHN’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 VAHN, 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 highly recommend you to complete your research by taking a look at the following: