I am writing today to help inform people who are new to 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.
Neuren Pharmaceuticals Limited (ASX:NEU) is currently trading at a trailing P/E of 44.2, which is higher than the industry average of 19.6. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. 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.
Breaking down the Price-Earnings ratio
The P/E ratio is one of many ratios used in relative valuation. 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 NEU
Price-Earnings Ratio = Price per share ÷ Earnings per share
NEU Price-Earnings Ratio = A$1.25 ÷ A$0.0283 = 44.2x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as NEU, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 44.2, NEU’s P/E is higher than its industry peers (19.6). This implies that investors are overvaluing each dollar of NEU’s earnings. This multiple is a median of profitable companies of 5 Pharmaceuticals companies in AU including MMJ PhytoTech, Vita Life Sciences and Pharmaxis. You could think of it like this: the market is pricing NEU as if it is a stronger company than the average of its industry group.
Assumptions to be aware of
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 NEU. If not, the difference in P/E might be a result of other factors. For example, if Neuren Pharmaceuticals Limited 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 NEU 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:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in NEU. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for NEU’s future growth? Take a look at our free research report of analyst consensus for NEU’s outlook.
- Past Track Record: Has NEU 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 NEU’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.