A&W Revenue Royalties Income Fund (TSX:AW.UN) is currently trading at a trailing P/E of 19.7x, which is higher than the industry average of 18.9x. While this makes AW.UN appear like a stock to avoid or sell if you own it, 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. View our latest analysis for A&W Revenue Royalties Income Fund
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 AW.UN
Price-Earnings Ratio = Price per share ÷ Earnings per share
AW.UN Price-Earnings Ratio = 33.4 ÷ 1.692 = 19.7x
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 AW.UN, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 19.7x, AW.UN’s P/E is higher than its industry peers (18.9x). This implies that investors are overvaluing each dollar of AW.UN’s earnings. Therefore, according to this analysis, AW.UN is an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your AW.UN shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to AW.UN. 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 AW.UN, 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 AW.UN to are fairly valued by the market. If this does not hold, there is a possibility that AW.UN’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? 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 AW.UN. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If you are considering investing in AW.UN, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on A&W Revenue Royalties Income Fund for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
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.