Does Red Hat Inc’s (RHT) PE Ratio Signal A Selling Opportunity?

Red Hat Inc (NYSE:RHT) trades with a trailing P/E of 72.3x, which is higher than the industry average of 33.4x. While this makes RHT 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. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Red Hat

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.

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 RHT, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.

At 72.3x, RHT’s P/E is higher than its industry peers (33.4x). This implies that investors are overvaluing each dollar of RHT’s earnings. Therefore, according to this analysis, RHT is an over-priced stock.

A few caveats

However, before you rush out to sell your RHT shares, 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 RHT. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared lower growth firms with RHT, then RHT’s P/E would naturally be higher since investors would reward RHT’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with RHT, RHT’s P/E would again be higher since investors would reward RHT’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing RHT to are fairly valued by the market. If this assumption is violated, RHT’s P/E may be higher than its peers because its peers are actually undervalued by investors.

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 rebalance your portfolio and reduce your holdings in RHT. 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 RHT, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.

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 Red Hat 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.