I am writing today to help inform people who are new to the stock market and want to begin learning the link between Yellow Brick Road Holdings Limited (ASX:YBR)’s fundamentals and stock market performance.
Yellow Brick Road Holdings Limited (ASX:YBR) is trading with a trailing P/E of 29.3x, which is higher than the industry average of 20x. While YBR might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View out our latest analysis for Yellow Brick Road Holdings
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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for YBR
Price per share = A$0.091
Earnings per share = A$0.00311
∴ Price-Earnings Ratio = A$0.091 ÷ A$0.00311 = 29.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 YBR, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. 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.
YBR’s P/E of 29.3x is higher than its industry peers (20x), which implies that each dollar of YBR’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 9 Diversified Financial companies in AU including Gowing Bros, AMP and Pioneer Credit. Therefore, according to this analysis, YBR is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that YBR should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to YBR. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared lower growth firms with YBR, then YBR’s P/E would naturally be higher since investors would reward YBR’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with YBR, YBR’s P/E would again be higher since investors would reward YBR’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing YBR to are fairly valued by the market. If this does not hold, there is a possibility that YBR’s P/E is higher because firms in our peer group are being undervalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to YBR. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 highly recommend you to complete your research by taking a look at the following:
- Financial Health: Is YBR’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.
- Past Track Record: Has YBR 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 YBR’s historicals for more clarity.
- 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.