El Paso Electric Company (NYSE:EE) is trading with a trailing P/E of 21x, which is higher than the industry average of 16.8x. While this makes EE 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 explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for El Paso Electric
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 EE
Price per share = $50.5
Earnings per share = $2.401
∴ Price-Earnings Ratio = $50.5 ÷ $2.401 = 21x
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 EE, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. 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.
Since EE’s P/E of 21x is higher than its industry peers (16.8x), it means that investors are paying more than they should for each dollar of EE’s earnings. Therefore, according to this analysis, EE is an over-priced stock.
A few caveats
Before you jump to the conclusion that EE should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to EE. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing riskier firms with EE, then EE’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 EE. In this case, EE’s P/E would be higher since investors would also reward EE’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing EE to are fairly valued by the market. If this assumption is violated, EE’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 EE. 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 EE’s future growth? Take a look at our free research report of analyst consensus for EE’s outlook.
- Past Track Record: Has EE 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 EE’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.