Lovisa Holdings Limited (ASX:LOV) trades with a trailing P/E of 25.2x, which is higher than the industry average of 16x. While LOV 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Lovisa Holdings
Demystifying the P/E 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 LOV
Price-Earnings Ratio = Price per share ÷ Earnings per share
LOV Price-Earnings Ratio = A$6.98 ÷ A$0.277 = 25.2x
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 LOV, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 25.2x, LOV’s P/E is higher than its industry peers (16x). This implies that investors are overvaluing each dollar of LOV’s earnings. Therefore, according to this analysis, LOV is an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your LOV shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to LOV, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with LOV, 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 LOV to are fairly valued by the market. If this does not hold, there is a possibility that LOV’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to LOV. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.