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 start learning about core concepts of fundamental analysis on practical examples from today’s market.
Innophos Holdings Inc (NASDAQ:IPHS) is trading with a trailing P/E of 49.6, which is higher than the industry average of 22.5. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Breaking down the P/E ratio
P/E is a popular ratio used for relative valuation. 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 IPHS
Price-Earnings Ratio = Price per share ÷ Earnings per share
IPHS Price-Earnings Ratio = $44.34 ÷ $0.895 = 49.6x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to IPHS, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 49.6, IPHS’s P/E is higher than its industry peers (22.5). This implies that investors are overvaluing each dollar of IPHS’s earnings. This multiple is a median of profitable companies of 25 Chemicals companies in US including China SNX Organic Fertilizers, ONE Bio and China Green Agriculture. You could think of it like this: the market is pricing IPHS as if it is a stronger company than the average of its industry group.
Assumptions to be aware of
However, you should be aware that this analysis makes certain assumptions. The first is that our “similar companies” are actually similar to IPHS. If not, the difference in P/E might be a result of other factors. For example, if Innophos Holdings Inc is growing faster than its peers, then it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to IPHS may not be fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.
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 IPHS. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for IPHS’s future growth? Take a look at our free research report of analyst consensus for IPHS’s outlook.
- Past Track Record: Has IPHS 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 IPHS’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.