American Electric Power Company Inc (NYSE:AEP) is trading with a trailing P/E of 60.3x, which is higher than the industry average of 20.7x. While this makes AEP 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. In this article, 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 American Electric Power Company
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 AEP
Price-Earnings Ratio = Price per share ÷ Earnings per share
AEP Price-Earnings Ratio = 70.5 ÷ 1.169 = 60.3x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to AEP, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. AEP’s P/E of 60.3x is higher than its industry peers (20.7x), which implies that each dollar of AEP’s earnings is being overvalued by investors. As such, our analysis shows that AEP represents an over-priced stock.
A few caveats
However, before you rush out to sell your AEP 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 AEP. 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 AEP, 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 AEP to are fairly valued by the market. If this does not hold true, AEP’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? 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 AEP. 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.
Are you a potential investor? If you are considering investing in AEP, 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 American Electric Power Company 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.