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Is Meliá Hotels International SA’s (BME:MEL) PE Ratio A Signal To Sell For Investors?

I am writing today to help inform people who are new to the stock market and want to begin learning the link between Meliá Hotels International SA (BME:MEL)’s fundamentals and stock market performance.

Meliá Hotels International SA (BME:MEL) is trading with a trailing P/E of 21.8x, which is higher than the industry average of 19.3x. While this makes MEL 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.

Breaking down 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. 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.

Formula

Price-Earnings Ratio = Price per share ÷ Earnings per share

P/E Calculation for MEL

Price per share = €12.16

Earnings per share = €0.557

∴ Price-Earnings Ratio = €12.16 ÷ €0.557 = 21.8x

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. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to MEL, such as company lifetime and products sold. 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 21.8x, MEL’s P/E is higher than its industry peers (19.3x). This implies that investors are overvaluing each dollar of MEL’s earnings. Therefore, according to this analysis, MEL is an over-priced stock.

A few caveats

However, before you rush out to sell your MEL shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to MEL. 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 MEL, then investors would naturally value MEL at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with MEL, investors would also value MEL at a higher price since it is a higher growth investment. Both scenarios would explain why MEL has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing MEL to are fairly valued by the market. If this does not hold, there is a possibility that MEL’s P/E is higher because firms in our peer group are being undervalued 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 rebalance your portfolio and reduce your holdings in MEL. 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:

1. Future Outlook: What are well-informed industry analysts predicting for MEL’s future growth? Take a look at our free research report of analyst consensus for MEL’s outlook.
2. Past Track Record: Has MEL 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 MEL’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.