Is Majestic Wine plc's (LON:WINE) PE Ratio A Signal To Sell For Investors?

Majestic Wine plc (AIM:WINE) is currently trading at a trailing P/E of 103x, which is higher than the industry average of 25x. While this makes WINE 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Majestic Wine

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. 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 pound of the company’s earnings.

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 WINE, 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.

WINE’s P/E of 103x is higher than its industry peers (25x), which implies that each dollar of WINE’s earnings is being overvalued by investors. As such, our analysis shows that WINE represents an over-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to sell your WINE shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to WINE. 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 WINE, then investors would naturally value WINE at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with WINE, investors would also value WINE at a higher price since it is a higher growth investment. Both scenarios would explain why WINE has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing WINE to are fairly valued by the market. If this assumption is violated, WINE's P/E may be higher than its peers because its peers are actually undervalued by investors.

What this means for you:

Since you may have already conducted your due diligence on WINE, 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:

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

2. Past Track Record: Has WINE 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 WINE'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.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.