Phileo Australia Limited (ASX:PHI) is currently trading at a trailing P/E of 25x, which is higher than the industry average of 12.7x. While this makes PHI appear like a stock to avoid or sell if you own it, 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. See our latest analysis for Phileo Australia

Breaking down the P/E ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 PHI

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

PHI Price-Earnings Ratio = A$12.95 ÷ A$0.518 = 25x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to PHI, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since PHI’s P/E of 25x is higher than its industry peers (12.7x), it means that investors are paying more than they should for each dollar of PHI’s earnings. Therefore, according to this analysis, PHI is an over-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to sell your PHI shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to PHI. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with PHI, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing PHI to are fairly valued by the market. If this does not hold, there is a possibility that PHI’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 PHI, 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. 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:

1. Financial Health: Is PHI’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.

2. Past Track Record: Has PHI been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of PHI’s historicals for more clarity.

3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.

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.