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.
AZZ Inc (NYSE:AZZ) trades with a trailing P/E of 28.7x, which is higher than the industry average of 17.7x. While AZZ 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.
Demystifying 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 AZZ
Price-Earnings Ratio = Price per share ÷ Earnings per share
AZZ Price-Earnings Ratio = $53.9 ÷ $1.881 = 28.7x
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 AZZ, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 28.7x, AZZ’s P/E is higher than its industry peers (17.7x). This implies that investors are overvaluing each dollar of AZZ’s earnings. This multiple is a median of profitable companies of 25 Electrical companies in US including Vivint Solar, Highpower International and TCP International Holdings. As such, our analysis shows that AZZ represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that AZZ should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to AZZ. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with AZZ, 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 AZZ to are fairly valued by the market. If this does not hold true, AZZ’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
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 AZZ. 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. 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 AZZ’s future growth? Take a look at our free research report of analyst consensus for AZZ’s outlook.
- Past Track Record: Has AZZ 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 AZZ’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 email@example.com.