Fisher & Paykel Healthcare Corporation Limited (NZSE:FPH) trades with a trailing P/E of 44.2x, which is higher than the industry average of 39x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Fisher & Paykel Healthcare
What you need to know about the P/E ratio
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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for FPH
Price per share = 13.21
Earnings per share = 0.299
∴ Price-Earnings Ratio = 13.21 ÷ 0.299 = 44.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to FPH, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. 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.
At 44.2x, FPH’s P/E is higher than its industry peers (39x). This implies that investors are overvaluing each dollar of FPH’s earnings. As such, our analysis shows that FPH represents an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your FPH 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 FPH. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared riskier firms with FPH, then investors would naturally value FPH at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with FPH, investors would also value FPH at a higher price since it is a higher growth investment. Both scenarios would explain why FPH has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing FPH to are fairly valued by the market. If this assumption is violated, FPH’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 FPH. 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 FPH, 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 Fisher & Paykel Healthcare 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.