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 begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Northland Power Inc (TSE:NPI) is currently trading at a trailing P/E of 21.3x, which is lower than the industry average of 52.1x. While this makes NPI appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 NPI
Price per share = CA$24.89
Earnings per share = CA$1.17
∴ Price-Earnings Ratio = CA$24.89 ÷ CA$1.17 = 21.3x
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 NPI, such as size and country of operation. 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.
NPI’s P/E of 21.3x is lower than its industry peers (52.1x), which implies that each dollar of NPI’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 7 Renewable Energy companies in CA including Pattern Energy Group, Capital Power and Polaris Infrastructure. As such, our analysis shows that NPI represents an under-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to buy NPI immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to NPI. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with NPI, then NPI’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with NPI, NPI’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing NPI to are fairly valued by the market. If this does not hold, there is a possibility that NPI’s P/E is lower because firms in our peer group are being overvalued by the market.
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 add more of NPI to your portfolio. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for NPI’s future growth? Take a look at our free research report of analyst consensus for NPI’s outlook.
- Past Track Record: Has NPI 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 NPI’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.