Yellow Brick Road Holdings Limited (ASX:YBR) is currently trading at a trailing P/E of 27.1x, which is higher than the industry average of 19.4x. 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Yellow Brick Road Holdings
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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$0.12
Earnings per share = A$0.004
∴ Price-Earnings Ratio = A$0.12 ÷ A$0.004 = 27.1x
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 YBR, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. 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.
Since YBR’s P/E of 27.1x is higher than its industry peers (19.4x), it means that investors are paying more than they should for each dollar of YBR’s earnings. As such, our analysis shows that YBR represents an over-priced stock.
A few caveats
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 are inadvertently comparing riskier firms with YBR, then YBR’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with YBR. In this case, YBR’s P/E would be higher since investors would also reward YBR’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing YBR to are fairly valued by the market. If this assumption does not hold true, YBR’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you: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 YBR. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 highly recommend you to complete your research by taking a look at the following:
1. 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.
2. 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.
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.