The content of this article will benefit those of you who are starting to educate yourself about investing in 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.
EVRAZ plc (LON:EVR) is currently trading at a trailing P/E of 14.7x, which is higher than the industry average of 12.1x. While EVR 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
Breaking down the Price-Earnings 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 pound of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for EVR
Price per share = $7.22
Earnings per share = $0.490
∴ Price-Earnings Ratio = $7.22 ÷ $0.490 = 14.7x
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 EVR, 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 it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
EVR’s P/E of 14.7x is higher than its industry peers (12.1x), which implies that each dollar of EVR’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Metals and Mining companies in GB including Cora Gold, Patagonia Gold and Ferrexpo. As such, our analysis shows that EVR represents an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that EVR should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to EVR. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing riskier firms with EVR, then EVR’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 EVR. In this case, EVR’s P/E would be higher since investors would also reward EVR’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing EVR to are fairly valued by the market. If this assumption does not hold true, EVR’s higher P/E ratio may be 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 EVR, 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 EVR’s future growth? Take a look at our free research report of analyst consensus for EVR’s outlook.
- Past Track Record: Has EVR 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 EVR’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.