Does Macmahon Holdings Limited's (ASX:MAH) PE Ratio Signal A Selling Opportunity?

Macmahon Holdings Limited (ASX:MAH) is trading with a trailing P/E of 44.8x, which is higher than the industry average of 13.4x. While this makes MAH 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. Check out our latest analysis for Macmahon Holdings

Breaking down the Price-Earnings ratio

P/E is a popular ratio used for 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.

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 MAH, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will 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.

MAH’s P/E of 44.8x is higher than its industry peers (13.4x), which implies that each dollar of MAH’s earnings is being overvalued by investors. As such, our analysis shows that MAH represents an over-priced stock.

Assumptions to be aware of

However, before you rush out to sell your MAH 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 MAH. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing riskier firms with MAH, then MAH’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 MAH. In this case, MAH’s P/E would be higher since investors would also reward MAH’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing MAH to are fairly valued by the market. If this assumption does not hold true, MAH’s higher P/E ratio may be 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 MAH. 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:

1. Future Outlook: What are well-informed industry analysts predicting for MAH’s future growth? Take a look at our free research report of analyst consensus for MAH’s outlook.
2. Past Track Record: Has MAH 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 MAH'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.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.