EBOS Group Limited (NZSE:EBO) is currently trading at a trailing P/E of 20.9x, which is higher than the industry average of 8.7x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for EBOS Group
Breaking down the Price-Earnings 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for EBO
Price per share = NZ$18.39
Earnings per share = NZ$0.878
∴ Price-Earnings Ratio = NZ$18.39 ÷ NZ$0.878 = 20.9x
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. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as EBO, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. 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 20.9x, EBO’s P/E is higher than its industry peers (8.7x). This implies that investors are overvaluing each dollar of EBO’s earnings. Therefore, according to this analysis, EBO is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that EBO 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 EBO. 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 EBO, then EBO’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 EBO. In this case, EBO’s P/E would be higher since investors would also reward EBO’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing EBO to are fairly valued by the market. If this assumption is violated, EBO’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 EBO, 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 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 EBO’s future growth? Take a look at our free research report of analyst consensus for EBO’s outlook.
- 2. Past Track Record: Has EBO 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 EBO’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.