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.
NH Hotel Group SA (BME:NHH) is trading with a trailing P/E of 60.3x, which is higher than the industry average of 19.9x. While NHH 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.
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 NHH
Price per share = €6.33
Earnings per share = €0.105
∴ Price-Earnings Ratio = €6.33 ÷ €0.105 = 60.3x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against 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 NHH, 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.
NHH’s P/E of 60.3x is higher than its industry peers (19.9x), which implies that each dollar of NHH’s earnings is being overvalued by investors. Since the Hospitality sector in ES is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as Telepizza Group, Meliá Hotels International and Parques Reunidos Servicios Centrales. As such, our analysis shows that NHH represents an over-priced stock.
A few caveats
However, before you rush out to sell your NHH 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 NHH. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing riskier firms with NHH, then NHH’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with NHH. In this case, NHH’s P/E would be higher since investors would also reward NHH’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing NHH to are fairly valued by the market. If this does not hold, there is a possibility that NHH’s P/E is higher 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 NHH, 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for NHH’s future growth? Take a look at our free research report of analyst consensus for NHH’s outlook.
- Past Track Record: Has NHH 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 NHH’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 pass 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.