Hargreaves Lansdown plc (LSE:HL.) is currently trading at a trailing P/E of 40.4x, which is higher than the industry average of 17.1x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Hargreaves Lansdown
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 pound of the company’s earnings.
P/E Calculation for HL.
Price-Earnings Ratio = Price per share ÷ Earnings per share
HL. Price-Earnings Ratio = £18.02 ÷ £0.446 = 40.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as HL., such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since HL.’s P/E of 40.4x is higher than its industry peers (17.1x), it means that investors are paying more than they should for each dollar of HL.’s earnings. Therefore, according to this analysis, HL. is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your HL. shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to HL.. 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 HL., 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 HL. to are fairly valued by the market. If this does not hold, there is a possibility that HL.’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 HL.. 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 HL., basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.
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 Hargreaves Lansdown 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.