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.
Radisson Hospitality AB (publ) (STO:RADH) is trading with a trailing P/E of 24.4x, which is higher than the industry average of 16.1x. While RADH 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 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 Radisson Hospitality
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 RADH
Price-Earnings Ratio = Price per share ÷ Earnings per share
RADH Price-Earnings Ratio = €3.42 ÷ €0.140 = 24.4x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as RADH, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since RADH’s P/E of 24.4x is higher than its industry peers (16.1x), it means that investors are paying more than they should for each dollar of RADH’s earnings. This multiple is a median of profitable companies of 22 Hospitality companies in SE including Global Gaming 555, Pandox and Betsson. Therefore, according to this analysis, RADH is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your RADH shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to RADH. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with RADH, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing RADH to are fairly valued by the market. If this is violated, RADH’s P/E may be lower than its peers as they are actually overvalued by investors.