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 begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Eagle Pharmaceuticals Inc (NASDAQ:EGRX) is trading with a trailing P/E of 29.8, which is higher than the industry average of 25.2. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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.
What you need to know about the P/E 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 EGRX
Price-Earnings Ratio = Price per share ÷ Earnings per share
EGRX Price-Earnings Ratio = $59.49 ÷ $1.998 = 29.8x
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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as EGRX, 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. EGRX’s P/E of 29.8 is higher than its industry peers (25.2), which implies that each dollar of EGRX’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 24 Biotechs companies in US including Portage Biotech, Ophthotech and Kiwa Bio-Tech Products Group. You could think of it like this: the market is pricing EGRX as if it is a stronger company than the average of its industry group.
Assumptions to be aware of
However, it is important to note that our examination of the stock is based on certain assumptions. Firstly, that our peer group contains companies that are similar to EGRX. If this isn’t the case, the difference in P/E could be due to other factors. For example, Eagle Pharmaceuticals Inc could be growing more quickly than the companies we’re comparing it with. In that case it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to EGRX 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 EGRX. 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 EGRX’s future growth? Take a look at our free research report of analyst consensus for EGRX’s outlook.
- Past Track Record: Has EGRX 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 EGRX’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.