Northrop Grumman Corporation (NYSE:NOC) is currently trading at a trailing P/E of 29.5x, which is higher than the industry average of 22.4x. While this makes NOC 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Northrop Grumman
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 NOC
Price per share = $340.82
Earnings per share = $11.554
∴ Price-Earnings Ratio = $340.82 ÷ $11.554 = 29.5x
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 NOC, 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 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.
NOC’s P/E of 29.5x is higher than its industry peers (22.4x), which implies that each dollar of NOC’s earnings is being overvalued by investors. Therefore, according to this analysis, NOC is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your NOC shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to NOC. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared lower growth firms with NOC, then NOC’s P/E would naturally be higher since investors would reward NOC’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with NOC, NOC’s P/E would again be higher since investors would reward NOC’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing NOC to are fairly valued by the market. If this assumption does not hold true, NOC’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to NOC. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 NOC’s future growth? Take a look at our free research report of analyst consensus for NOC’s outlook.
- Past Track Record: Has NOC 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 NOC’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.