This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Coffee Holding Co Inc (NASDAQ:JVA) is trading with a trailing P/E of 26.2, which is higher than the industry average of 18.8. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Breaking down the Price-Earnings ratio
The P/E ratio is one of many ratios used in relative valuation. 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 JVA
Price-Earnings Ratio = Price per share ÷ Earnings per share
JVA Price-Earnings Ratio = $4.63 ÷ $0.176 = 26.2x
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 JVA, 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. Since JVA’s P/E of 26.2 is higher than its industry peers (18.8), it means that investors are paying more for each dollar of JVA’s earnings. This multiple is a median of profitable companies of 25 Food companies in US including Royal Hawaiian Orchards, Kaibo Foods and China Modern Agricultural Information. You could think of it like this: the market is pricing JVA as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
However, you should be aware that this analysis makes certain assumptions. The first is that our “similar companies” are actually similar to JVA. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where Coffee Holding Co Inc is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with JVA are not fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.
What this means for you:
Since you may have already conducted your due diligence on JVA, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for JVA’s future growth? Take a look at our free research report of analyst consensus for JVA’s outlook.
- Past Track Record: Has JVA been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of JVA’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.