Limoneira Company (NASDAQ:LMNR) is currently trading at a trailing P/E of 37.6x, which is higher than the industry average of 21.6x. While this makes LMNR 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. In this article, 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 Limoneira
What you need to know about the P/E 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 LMNR
Price-Earnings Ratio = Price per share ÷ Earnings per share
LMNR Price-Earnings Ratio = $22.86 ÷ $0.608 = 37.6x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to LMNR, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. LMNR’s P/E of 37.6x is higher than its industry peers (21.6x), which implies that each dollar of LMNR’s earnings is being overvalued by investors. As such, our analysis shows that LMNR represents an over-priced stock.
A few caveats
However, before you rush out to sell your LMNR 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 LMNR, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with LMNR, 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 LMNR to are fairly valued by the market. If this does not hold true, LMNR’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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 LMNR. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.