Ares Management LP (NYSE:ARES) is currently trading at a trailing P/E of 25.1x, which is higher than the industry average of 19x. 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. 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. Check out our latest analysis for Ares Management
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in 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 ARES
Price-Earnings Ratio = Price per share ÷ Earnings per share
ARES Price-Earnings Ratio = 18.85 ÷ 0.751 = 25.1x
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 ARES, 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. Since ARES's P/E of 25.1x is higher than its industry peers (19x), it means that investors are paying more than they should for each dollar of ARES's earnings. Therefore, according to this analysis, ARES is an over-priced stock.
A few caveats
However, before you rush out to sell your ARES 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 ARES. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with ARES, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing ARES to are fairly valued by the market. If this does not hold, there is a possibility that ARES’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on ARES, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.
Are you a potential investor? If you are considering investing in ARES, 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 Ares Management 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.