Yellow Brick Road Holdings Limited (ASX:YBR) is currently trading at a trailing P/E of 43.4x, which is higher than the industry average of 19.6x. While this makes YBR 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Yellow Brick Road Holdings
Breaking down the Price-Earnings ratio
The P/E ratio is one of many ratios used in relative valuation. 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 YBR
Price per share = A$0.14
Earnings per share = A$0.003
∴ Price-Earnings Ratio = A$0.14 ÷ A$0.003 = 43.4x
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 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 43.4x, YBR’s P/E is higher than its industry peers (19.6x). This implies that investors are overvaluing each dollar of YBR’s earnings. Therefore, according to this analysis, YBR is an over-priced stock.
Assumptions to be aware of
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 “similar companies” are actually similar to YBR. 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 YBR, then investors would naturally value YBR at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with YBR, investors would also value YBR at a higher price since it is a higher growth investment. Both scenarios would explain why YBR has a higher P/E ratio than its peers. 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:
Since you may have already conducted your due diligence on YBR, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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 urge 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.