This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Vista Group International Limited (NZSE:VGL) trades with a trailing P/E of 63.1x, which is higher than the industry average of 30.3x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Vista Group International
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 VGL
Price per share = NZ$3.71
Earnings per share = NZ$0.0588
∴ Price-Earnings Ratio = NZ$3.71 ÷ NZ$0.0588 = 63.1x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to VGL, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will 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.
VGL’s P/E of 63.1x is higher than its industry peers (30.3x), which implies that each dollar of VGL’s earnings is being overvalued by investors. Since the Software sector in NZ 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 Enprise Group, Finzsoft Solutions and . As such, our analysis shows that VGL represents an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your VGL shares immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to VGL. 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 VGL, then VGL’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 VGL. In this case, VGL’s P/E would be higher since investors would also reward VGL’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing VGL to are fairly valued by the market. If this assumption is violated, VGL’s P/E may be higher than its peers because its peers are actually undervalued by investors.
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 VGL. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for VGL’s future growth? Take a look at our free research report of analyst consensus for VGL’s outlook.
- Past Track Record: Has VGL 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 VGL’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.