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.
Jazz Pharmaceuticals plc (NASDAQ:JAZZ) is currently trading at a trailing P/E of 23.7x, which is lower than the industry average of 29.1x. Although some investors may jump to the conclusion that this is a great buying opportunity, 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.
What you need to know about the P/E ratio
P/E is a popular ratio used for 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 JAZZ
Price-Earnings Ratio = Price per share ÷ Earnings per share
JAZZ Price-Earnings Ratio = $171.46 ÷ $7.228 = 23.7x
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 JAZZ, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. At 23.7, JAZZ’s P/E is lower than its industry peers (29.1). This implies that investors are undervaluing each dollar of JAZZ’s earnings. This multiple is a median of profitable companies of 24 Pharmaceuticals companies in US including Osteologix Holdings, Mallinckrodt and Biostar Pharmaceuticals. One could put it like this: the market is pricing JAZZ as if it is a weaker company than the average company in its industry.
A few caveats
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to JAZZ. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with JAZZ, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing JAZZ to are fairly valued by the market. If this does not hold, there is a possibility that JAZZ’s P/E is lower because our peer group is overvalued by the market.
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 add more of JAZZ to your portfolio. 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 JAZZ’s future growth? Take a look at our free research report of analyst consensus for JAZZ’s outlook.
- Past Track Record: Has JAZZ 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 JAZZ’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.