Link Administration Holdings Limited (ASX:LNK) is trading with a trailing P/E of 36.4x, which is higher than the industry average of 25.4x. 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Link Administration Holdings
Breaking down the P/E 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.
P/E Calculation for LNK
Price-Earnings Ratio = Price per share ÷ Earnings per share
LNK Price-Earnings Ratio = A$8.56 ÷ A$0.235 = 36.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to LNK, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 36.4x, LNK’s P/E is higher than its industry peers (25.4x). This implies that investors are overvaluing each dollar of LNK’s earnings. Therefore, according to this analysis, LNK is an over-priced stock.
A few caveats
However, before you rush out to sell your LNK 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 LNK, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with LNK, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing LNK to are fairly valued by the market. If this is violated, LNK’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? 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 LNK. 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.
Are you a potential investor? If you are considering investing in LNK, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.