Dominion Diamond Corporation (TSX:DDC) is currently trading at a trailing P/E of 20.2x, which is higher than the industry average of 10.4x. 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 explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Dominion Diamond
What you need to know about the P/E 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 dollar of the company’s earnings.
P/E Calculation for DDC
Price-Earnings Ratio = Price per share ÷ Earnings per share
DDC Price-Earnings Ratio = 17.76 ÷ 0.705 = 20.2x
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 DDC, 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. At 20.2x, DDC’s P/E is higher than its industry peers (10.4x). This implies that investors are overvaluing each dollar of DDC’s earnings. As such, our analysis shows that DDC represents an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your DDC shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to DDC, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with DDC, 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 DDC to are fairly valued by the market. If this does not hold true, DDC’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? 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 DDC. 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 DDC has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
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 Dominion Diamond 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.