I am writing today to help inform people who are new to the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Luna Innovations Incorporated (NASDAQ:LUNA) is trading with a trailing P/E of 59.4, which is higher than the industry average of 24.9. 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.
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in 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 LUNA
Price-Earnings Ratio = Price per share ÷ Earnings per share
LUNA Price-Earnings Ratio = $3.79 ÷ $0.0639 = 59.4x
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 LUNA, 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. LUNA’s P/E of 59.4 is higher than its industry peers (24.9), which implies that each dollar of LUNA’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Electronic companies in US including ProPhotonix, Electro Scientific Industries and Hosiden. You could think of it like this: the market is pricing LUNA as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to LUNA. If not, the difference in P/E might be a result of other factors. For example, if Luna Innovations Incorporated 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 LUNA may not be 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:
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 LUNA. 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:
- Financial Health: Are LUNA’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has LUNA 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 LUNA’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.