I am writing today to help inform people who are new to 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.
MLP SE (FRA:MLP) is currently trading at a trailing P/E of 22x, which is higher than the industry average of 17.7x. 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. Today, I will explain what the P/E ratio is as well as what you should look out for when using it.
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 MLP
Price per share = €5.46
Earnings per share = €0.248
∴ Price-Earnings Ratio = €5.46 ÷ €0.248 = 22x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 MLP, 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.
At 22x, MLP’s P/E is higher than its industry peers (17.7x). This implies that investors are overvaluing each dollar of MLP’s earnings. This multiple is a median of profitable companies of 25 Capital Markets companies in DE including Solvesta, Routemaster Capital and Aberdeen International. As such, our analysis shows that MLP represents an over-priced stock.
A few caveats
However, before you rush out to sell your MLP 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 MLP. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with MLP, then investors would naturally value MLP at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with MLP, investors would also value MLP at a higher price since it is a higher growth investment. Both scenarios would explain why MLP has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing MLP to are fairly valued by the market. If this assumption is violated, MLP’s P/E may be higher than its peers because its peers are actually undervalued by investors.
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 MLP. 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:
- Future Outlook: What are well-informed industry analysts predicting for MLP’s future growth? Take a look at our free research report of analyst consensus for MLP’s outlook.
- Past Track Record: Has MLP 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 MLP’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.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.