Altaba Inc (NASDAQ:AABA) is trading with a trailing P/E of 40.3x, which is higher than the industry average of 29.3x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Altaba
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for 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 AABA
Price per share = $76.57
Earnings per share = $1.898
∴ Price-Earnings Ratio = $76.57 ÷ $1.898 = 40.3x
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. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to AABA, 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.
At 40.3x, AABA’s P/E is higher than its industry peers (29.3x). This implies that investors are overvaluing each dollar of AABA’s earnings. As such, our analysis shows that AABA represents an over-priced stock.
A few caveats
However, before you rush out to sell your AABA shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to AABA. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared lower growth firms with AABA, then AABA’s P/E would naturally be higher since investors would reward AABA’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with AABA, AABA’s P/E would again be higher since investors would reward AABA’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing AABA to are fairly valued by the market. If this does not hold, there is a possibility that AABA’s P/E is higher 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 AABA. 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:
- 1. Future Outlook: What are well-informed industry analysts predicting for AABA’s future growth? Take a look at our free research report of analyst consensus for AABA’s outlook.
- 2. Past Track Record: Has AABA 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 AABA’s historicals for more clarity.
- 3. 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.