Vital Healthcare Property Trust (NZSE:VHP) is trading with a trailing P/E of 4.3x, which is lower than the industry average of 9.2x. While this makes VHP 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 explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Vital Healthcare Property Trust
Breaking down 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.
Formula
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for VHP
Price per share = 2.25
Earnings per share = 0.517
∴ Price-Earnings Ratio = 2.25 ÷ 0.517 = 4.3x
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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as VHP, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
Since VHP's P/E of 4.3x is lower than its industry peers (9.2x), it means that investors are paying less than they should for each dollar of VHP's earnings. Therefore, according to this analysis, VHP is an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy VHP, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to VHP. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with VHP, then investors would naturally value VHP at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with VHP, investors would also value VHP at a lower price since it is a lower growth investment. Both scenarios would explain why VHP has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing VHP to are fairly valued by the market. If this does not hold, there is a possibility that VHP’s P/E is lower because firms in our peer group are being overvalued by the market.