KLX Inc (NASDAQ:KLXI) trades with a trailing P/E of 38x, which is higher than the industry average of 20x. While KLXI might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for KLX
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 KLXI
Price-Earnings Ratio = Price per share ÷ Earnings per share
KLXI Price-Earnings Ratio = $61.76 ÷ $1.627 = 38x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to KLXI, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. KLXI’s P/E of 38x is higher than its industry peers (20x), which implies that each dollar of KLXI’s earnings is being overvalued by investors. As such, our analysis shows that KLXI represents an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that KLXI should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to KLXI. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with KLXI, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing KLXI to are fairly valued by the market. If this does not hold, there is a possibility that KLXI’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 KLXI, 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 you are considering investing in KLXI, 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.