This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
National Presto Industries Inc (NYSE:NPK) is currently trading at a trailing P/E of 20.9x, which is lower than the industry average of 24.2x. While NPK might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying the P/E 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 dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for NPK
Price per share = $137.95
Earnings per share = $6.598
∴ Price-Earnings Ratio = $137.95 ÷ $6.598 = 20.9x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to NPK, 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.
NPK’s P/E of 20.9x is lower than its industry peers (24.2x), which implies that each dollar of NPK’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 25 Aerospace & Defense companies in US including Optex Systems Holdings, Environmental Tectonics and Vectrus. As such, our analysis shows that NPK represents an under-priced stock.
A few caveats
While our conclusion might prompt you to buy NPK immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to NPK. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing lower risk firms with NPK, then NPK’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with NPK. In this case, NPK’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing NPK to are fairly valued by the market. If this assumption does not hold true, NPK’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on NPK, the undervaluation of the stock may mean it is a good time to top up on 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 NPK’s future growth? Take a look at our free research report of analyst consensus for NPK’s outlook.
- Past Track Record: Has NPK 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 NPK’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.