Brookfield Asset Management Inc (TSX:BAM.A) trades with a trailing P/E of 20.1x, which is higher than the industry average of 11.2x. While BAM.A might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, 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 Brookfield Asset Management
Breaking down the Price-Earnings 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for BAM.A
Price per share = $40.54
Earnings per share = $2.019
∴ Price-Earnings Ratio = $40.54 ÷ $2.019 = 20.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as BAM.A, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. 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.
BAM.A’s P/E of 20.1x is higher than its industry peers (11.2x), which implies that each dollar of BAM.A’s earnings is being overvalued by investors. As such, our analysis shows that BAM.A represents an over-priced stock.
A few caveats
Before you jump to the conclusion that BAM.A 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 BAM.A. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared lower growth firms with BAM.A, then BAM.A’s P/E would naturally be higher since investors would reward BAM.A’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with BAM.A, BAM.A’s P/E would again be higher since investors would reward BAM.A’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing BAM.A to are fairly valued by the market. If this assumption does not hold true, BAM.A’s higher P/E ratio may be 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 BAM.A, 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 highly recommend you to complete your research by taking a look at the following:
- Financial Health: Is BAM.A’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 BAM.A 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 BAM.A’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.