New England Realty Associates Limited Partnership (AMEX:NEN) is currently trading at a trailing P/E of 40x, which is higher than the industry average of 13x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for New England Realty Associates Limited Partnership
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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 NEN
Price-Earnings Ratio = Price per share ÷ Earnings per share
NEN Price-Earnings Ratio = $72.5 ÷ $1.815 = 40x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to NEN, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since NEN’s P/E of 40x is higher than its industry peers (13x), it means that investors are paying more than they should for each dollar of NEN’s earnings. Therefore, according to this analysis, NEN is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that NEN 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 NEN. 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 NEN, 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 NEN to are fairly valued by the market. If this does not hold true, NEN’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
To help readers see pass 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.