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This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Diamond Hill Investment Group Inc (NASDAQ:DHIL) trades with a trailing P/E of 11.5x, which is lower than the industry average of 21.7x. While this makes DHIL appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 DHIL
Price-Earnings Ratio = Price per share ÷ Earnings per share
DHIL Price-Earnings Ratio = $171 ÷ $14.919 = 11.5x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as DHIL, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since DHIL’s P/E of 11.5 is lower than its industry peers (21.7), it means that investors are paying less for each dollar of DHIL’s earnings. This multiple is a median of profitable companies of 24 Capital Markets companies in US including Viking Energy Group, TheStreet and China Internet Nationwide Financial Services. One could put it like this: the market is pricing DHIL as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to DHIL. 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 DHIL, 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 DHIL to are fairly valued by the market. If this is violated, DHIL’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of DHIL to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 urge you to complete your research by taking a look at the following:
Future Outlook: What are well-informed industry analysts predicting for DHIL’s future growth? Take a look at our free research report of analyst consensus for DHIL’s outlook.
Past Track Record: Has DHIL 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 DHIL’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.