I am writing today to help inform people who are new to the stock market and want to begin learning the link between Praxair Inc (NYSE:PX)’s fundamentals and stock market performance.
Praxair Inc (NYSE:PX) is trading with a trailing P/E of 34.4x, which is higher than the industry average of 16.7x. While this makes PX 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. Today, 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 Praxair
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 PX
Price per share = $158.47
Earnings per share = $4.603
∴ Price-Earnings Ratio = $158.47 ÷ $4.603 = 34.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as PX, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. 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.
PX’s P/E of 34.4x is higher than its industry peers (16.7x), which implies that each dollar of PX’s earnings is being overvalued by investors. As such, our analysis shows that PX represents an over-priced stock.
A few caveats
However, before you rush out to sell your PX 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 PX. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared riskier firms with PX, then investors would naturally value PX at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with PX, investors would also value PX at a higher price since it is a higher growth investment. Both scenarios would explain why PX has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing PX to are fairly valued by the market. If this does not hold, there is a possibility that PX’s P/E is higher 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 PX. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for PX’s future growth? Take a look at our free research report of analyst consensus for PX’s outlook.
- Past Track Record: Has PX 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 PX’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.