Ormat Technologies Inc (NYSE:ORA) trades with a trailing P/E of 27.3x, which is higher than the industry average of 16.8x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for ORA
Breaking down the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 ORA
Price per share = $64.5
Earnings per share = $2.361
∴ Price-Earnings Ratio = $64.5 ÷ $2.361 = 27.3x
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 ORA, 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.
Since ORA’s P/E of 27.3x is higher than its industry peers (16.8x), it means that investors are paying more than they should for each dollar of ORA’s earnings. As such, our analysis shows that ORA represents an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your ORA shares immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to ORA. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with ORA, then investors would naturally value ORA at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with ORA, investors would also value ORA at a higher price since it is a higher growth investment. Both scenarios would explain why ORA has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing ORA to are fairly valued by the market. If this does not hold, there is a possibility that ORA’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 ORA. 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:
1. Future Outlook: What are well-informed industry analysts predicting for ORA’s future growth? Take a look at our free research report of analyst consensus for ORA’s outlook.
2. Past Track Record: Has ORA 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 ORA’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.