Friedman Industries Incorporated (AMEX:FRD) is currently trading at a trailing P/E of 192.7x, which is higher than the industry average of 12.2x. 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 Friedman Industries
Demystifying the P/E 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 FRD
Price-Earnings Ratio = Price per share ÷ Earnings per share
FRD Price-Earnings Ratio = $6.23 ÷ $0.032 = 192.7x
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 FRD, 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. FRD’s P/E of 192.7x is higher than its industry peers (12.2x), which implies that each dollar of FRD’s earnings is being overvalued by investors. As such, our analysis shows that FRD represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your FRD shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to FRD. 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 FRD, 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 FRD to are fairly valued by the market. If this does not hold true, FRD’s lower P/E ratio may be because firms in our peer group are 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 rebalance your portfolio and reduce your holdings in FRD. 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:
- Financial Health: Is FRD’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has FRD 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 FRD’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 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.