AFH Financial Group Plc (AIM:AFHP) is trading with a trailing P/E of 34.4x, which is higher than the industry average of 17.3x. While this makes AFHP 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for AFH Financial Group
What you need to know about the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for AFHP
Price per share = £2.73
Earnings per share = £0.079
∴ Price-Earnings Ratio = £2.73 ÷ £0.079 = 34.4x
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 AFHP, 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 34.4x, AFHP’s P/E is higher than its industry peers (17.3x). This implies that investors are overvaluing each dollar of AFHP’s earnings. Therefore, according to this analysis, AFHP is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your AFHP shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to AFHP. 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 AFHP, then investors would naturally value AFHP at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with AFHP, investors would also value AFHP at a higher price since it is a higher growth investment. Both scenarios would explain why AFHP has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing AFHP to are fairly valued by the market. If this assumption does not hold true, AFHP’s higher P/E ratio may be 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 AFHP. 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 urge you to complete your research by taking a look at the following:
1. Financial Health: Is AFHP’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
2. Past Track Record: Has AFHP 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 AFHP’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.