Almost Family Inc (NASDAQ:AFAM) trades with a trailing P/E of 47.8x, which is higher than the industry average of 21.5x. While this makes AFAM 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Almost Family
Breaking down 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 AFAM
Price-Earnings Ratio = Price per share ÷ Earnings per share
AFAM Price-Earnings Ratio = $57.65 ÷ $1.206 = 47.8x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AFAM, 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. AFAM’s P/E of 47.8x is higher than its industry peers (21.5x), which implies that each dollar of AFAM’s earnings is being overvalued by investors. Therefore, according to this analysis, AFAM is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your AFAM shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to AFAM, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with AFAM, 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 AFAM to are fairly valued by the market. If this does not hold, there is a possibility that AFAM’s P/E is lower because our peer group is 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 AFAM. 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 AFAM, 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 Almost Family 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.