EMC Insurance Group Inc (NASDAQ:EMCI) trades with a trailing P/E of 18.3x, which is higher than the industry average of 17.3x. While this makes EMCI 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 EMC Insurance Group
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 EMCI
Price-Earnings Ratio = Price per share ÷ Earnings per share
EMCI Price-Earnings Ratio = $29.6 ÷ $1.616 = 18.3x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to EMCI, 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. EMCI’s P/E of 18.3x is higher than its industry peers (17.3x), which implies that each dollar of EMCI’s earnings is being overvalued by investors. Therefore, according to this analysis, EMCI is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your EMCI shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to EMCI. 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 EMCI, 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 EMCI to are fairly valued by the market. If this is violated, EMCI’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? 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 EMCI. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in EMCI, 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.