Brookfield Asset Management Inc (TSX:BAM.A) is trading with a trailing P/E of 93.4x, which is higher than the industry average of 12.7x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. 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 Brookfieldset Management
What you need to know about the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 = $43.83
Earnings per share = $0.469
∴ Price-Earnings Ratio = $43.83 ÷ $0.469 = 93.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to BAM.A, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. 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.
Since BAM.A’s P/E of 93.4x is higher than its industry peers (12.7x), it means that investors are paying more than they should for each dollar of BAM.A’s earnings. As such, our analysis shows that BAM.A represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your BAM.A shares immediately, there are two important assumptions you should be aware of. 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 inadvertently compared riskier firms with BAM.A, then investors would naturally value BAM.A at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with BAM.A, investors would also value BAM.A at a higher price since it is a higher growth investment. Both scenarios would explain why BAM.A has a higher P/E ratio than its peers. 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: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 BAM.A. 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. 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.
2. 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.
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.