Should You Sell Orocobre Limited (ASX:ORE) At This PE Ratio?

The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to better understand how you can grow your money by investing in Orocobre Limited (ASX:ORE).

Orocobre Limited (ASX:ORE) trades with a trailing P/E of 155.2x, which is higher than the industry average of 13.5x. While this makes ORE 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Orocobre

Demystifying the P/E ratio

P/E is often used for relative valuation since earnings power is a chief 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.

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as ORE, such as size and country of operation. 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 155.2x, ORE’s P/E is higher than its industry peers (13.5x). This implies that investors are overvaluing each dollar of ORE’s earnings. Therefore, according to this analysis, ORE is an over-priced stock.

A few caveats

However, before you rush out to sell your ORE shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to ORE. 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 ORE, then ORE’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 ORE. In this case, ORE’s P/E would be higher since investors would also reward ORE’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing ORE to are fairly valued by the market. If this assumption is violated, ORE's P/E may be higher than its peers because its peers are actually undervalued by investors.

What this means for you:

Since you may have already conducted your due diligence on ORE, 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:

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