Berkshire Hathaway Inc (NYSE:BRK.A) is currently trading at a trailing P/E of 25.6x, which is higher than the industry average of 14x. While this makes BRK.A 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 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 Berkshire Hathaway
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 BRK.A
Price-Earnings Ratio = Price per share ÷ Earnings per share
BRK.A Price-Earnings Ratio = $291000.2 ÷ $11356.346 = 25.6x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as BRK.A, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. BRK.A’s P/E of 25.6x is higher than its industry peers (14x), which implies that each dollar of BRK.A’s earnings is being overvalued by investors. As such, our analysis shows that BRK.A represents an over-priced stock.
A few caveats
However, before you rush out to sell your BRK.A shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to BRK.A. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with BRK.A, 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 BRK.A to are fairly valued by the market. If this does not hold, there is a possibility that BRK.A’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on BRK.A, 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.
Are you a potential investor? If BRK.A has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.