Should you buy Bed Bath & Beyond Inc (BBBY) based on it’s P/E ratio?

Bed Bath & Beyond Inc (NASDAQ:BBBY) trades with a trailing P/E of 6.4x, which is lower than the industry average of 19.7x. While BBBY might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for BBBY

Demystifying the P/E ratio

NasdaqGS:BBBY PE PEG Gauge Aug 31st 17
NasdaqGS:BBBY PE PEG Gauge Aug 31st 17

P/E is often used for relative valuation since earnings power is a chief 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.

Formula

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

P/E Calculation for BBBY

Price per share = 27.87

Earnings per share = 4.372

∴ Price-Earnings Ratio = 27.87 ÷ 4.372 = 6.4x

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 BBBY, 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. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.

Since BBBY’s P/E of 6.4x is lower than its industry peers (19.7x), it means that investors are paying less than they should for each dollar of BBBY’s earnings. Therefore, according to this analysis, BBBY is an under-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to buy BBBY immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to BBBY. 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 BBBY, then investors would naturally value BBBY at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with BBBY, investors would also value BBBY at a lower price since it is a lower growth investment. Both scenarios would explain why BBBY has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing BBBY to are fairly valued by the market. If this assumption does not hold true, BBBY’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.

NasdaqGS:BBBY Future Profit Aug 31st 17
NasdaqGS:BBBY Future Profit Aug 31st 17

What this means for you:

Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of BBBY to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.

Are you a potential investor? If you are considering investing in BBBY, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Bed Bath & Beyond for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.