This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between Neuren Pharmaceuticals Limited (ASX:NEU)’s fundamentals and stock market performance.
Neuren Pharmaceuticals Limited (ASX:NEU) is currently trading at a trailing P/E of 75.2x, which is higher than the industry average of 22.6x. While this makes NEU 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 Neuren Pharmaceuticals
Breaking down the P/E 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for NEU
Price per share = A$2.69
Earnings per share = A$0.0358
∴ Price-Earnings Ratio = A$2.69 ÷ A$0.0358 = 75.2x
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 NEU, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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.
NEU’s P/E of 75.2x is higher than its industry peers (22.6x), which implies that each dollar of NEU’s earnings is being overvalued by investors. As such, our analysis shows that NEU represents an over-priced stock.
A few caveats
However, before you rush out to sell your NEU 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 NEU. 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 NEU, then NEU’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 NEU. In this case, NEU’s P/E would be higher since investors would also reward NEU’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing NEU to are fairly valued by the market. If this assumption is violated, NEU’s P/E may be higher than its peers because its peers are actually undervalued by investors.
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 NEU. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for NEU’s future growth? Take a look at our free research report of analyst consensus for NEU’s outlook.
- Past Track Record: Has NEU 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 NEU’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.