I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
American Financial Group Inc (NYSE:AFG) trades with a trailing P/E of 20.8x, which is higher than the industry average of 14x. While AFG 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View out our latest analysis for American Financial Group
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 AFG
Price per share = $109.93
Earnings per share = $5.298
∴ Price-Earnings Ratio = $109.93 ÷ $5.298 = 20.8x
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 AFG, 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 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.
Since AFG’s P/E of 20.8x is higher than its industry peers (14x), it means that investors are paying more than they should for each dollar of AFG’s earnings. This multiple is a median of profitable companies of 25 Insurance companies in US including Rineon Group, UIB Group and Syncora Holdings. Therefore, according to this analysis, AFG is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your AFG shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to AFG. 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 riskier firms with AFG, then AFG’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 AFG. In this case, AFG’s P/E would be higher since investors would also reward AFG’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing AFG to are fairly valued by the market. If this assumption does not hold true, AFG’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
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 AFG. 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 AFG’s future growth? Take a look at our free research report of analyst consensus for AFG’s outlook.
- Past Track Record: Has AFG 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 AFG’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.