AMCON Distributing Company (AMEX:DIT) trades with a trailing P/E of 20x, which is higher than the industry average of 19.8x. While DIT 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. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for AMCON Distributing
Breaking down 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 DIT
Price per share = $94.5
Earnings per share = $4.73
∴ Price-Earnings Ratio = $94.5 ÷ $4.73 = 20x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to DIT, 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.
At 20x, DIT’s P/E is higher than its industry peers (19.8x). This implies that investors are overvaluing each dollar of DIT’s earnings. Therefore, according to this analysis, DIT is an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your DIT shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to DIT. 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 DIT, then DIT’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 DIT. In this case, DIT’s P/E would be higher since investors would also reward DIT’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing DIT to are fairly valued by the market. If this does not hold, there is a possibility that DIT’s P/E is higher because firms in our peer group are being undervalued by the market.
What this means for you:
Since you may have already conducted your due diligence on DIT, the overvaluation of the stock may mean it is a good time to reduce 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:
- Financial Health: Is DIT’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has DIT 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 DIT’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.