I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Harley-Davidson Inc (NYSE:HOG) is currently trading at a trailing P/E of 14x, which is higher than the industry average of 9.9x. 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 HOG
Price per share = $41
Earnings per share = $2.937
∴ Price-Earnings Ratio = $41 ÷ $2.937 = 14x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 HOG, such as capital structure and profitability. 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.
HOG’s P/E of 14x is higher than its industry peers (9.9x), which implies that each dollar of HOG’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Auto companies in US including New Dover Capital, Dongfeng Motor Group and Dongfeng Motor Group. Therefore, according to this analysis, HOG is an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your HOG 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 HOG. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with HOG, then investors would naturally value HOG at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with HOG, investors would also value HOG at a higher price since it is a higher growth investment. Both scenarios would explain why HOG has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing HOG to are fairly valued by the market. If this does not hold, there is a possibility that HOG’s P/E is higher 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 HOG, 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:
- Future Outlook: What are well-informed industry analysts predicting for HOG’s future growth? Take a look at our free research report of analyst consensus for HOG’s outlook.
- Past Track Record: Has HOG 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 HOG’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.