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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.
United Utilities Group PLC (LON:UU.) is trading with a trailing P/E of 13.5, which is close to the industry average of 14.2. 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. 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 United Utilities Group
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. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for UU.
Price-Earnings Ratio = Price per share ÷ Earnings per share
UU. Price-Earnings Ratio = £7.02 ÷ £0.520 = 13.5x
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 UU., such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. United Utilities Group PLC (LON:UU.) trades on a trailing P/E of 13.5. This isn’t too far from the industry average (which is 14.2). Since the Water Utilities 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 Pennon Group, Severn Trent and . You can think of it like this: the market is suggesting that UU. has similar prospects to its peers in the same industry.
Assumptions to watch out for
However, 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 UU., or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with UU., 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 UU. to are fairly valued by the market. If this does not hold, there is a possibility that UU.’s P/E is lower because our peer group is overvalued by the market.