In This Article:
The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
NEXT plc (LON:NXT) is trading with a trailing P/E of 12.5x, which is lower than the industry average of 21.7x. Although some investors may jump to the conclusion that this is a great buying opportunity, 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 NEXT
Breaking down the P/E 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 NXT
Price-Earnings Ratio = Price per share ÷ Earnings per share
NXT Price-Earnings Ratio = £52 ÷ £4.168 = 12.5x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as NXT, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. NXT’s P/E of 12.5 is lower than its industry peers (21.7), which implies that each dollar of NXT’s earnings is being undervalued by investors. Since the Multiline Retail sector in GB is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as B&M European Value Retail, Marks and Spencer Group and . You can think of it like this: the market is suggesting that NXT is a weaker business than the average comparable company.
A few caveats
However, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to NXT, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with NXT, 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 NXT to are fairly valued by the market. If this does not hold, there is a possibility that NXT’s P/E is lower because our peer group is overvalued by the market.