Ares Commercial Real Estate Corporation (NYSE:ACRE) is currently trading at a trailing P/E of 11x, which is higher than the industry average of 10.5x. While ACRE might seem like a stock to avoid or sell if you own it, 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. See our latest analysis for Ares Commercial Real Estate
Breaking down the Price-Earnings 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 ACRE
Price per share = $12.5
Earnings per share = $1.134
∴ Price-Earnings Ratio = $12.5 ÷ $1.134 = 11x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ACRE, such as company lifetime and products sold. 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.
ACRE’s P/E of 11x is higher than its industry peers (10.5x), which implies that each dollar of ACRE’s earnings is being overvalued by investors. Therefore, according to this analysis, ACRE is an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your ACRE shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to ACRE. 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 ACRE, then ACRE’s P/E would naturally be higher since investors would reward ACRE’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with ACRE, ACRE’s P/E would again be higher since investors would reward ACRE’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing ACRE to are fairly valued by the market. If this assumption is violated, ACRE’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 ACRE. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for ACRE’s future growth? Take a look at our free research report of analyst consensus for ACRE’s outlook.
- Past Track Record: Has ACRE 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 ACRE’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.