Nathan's Famous Inc (NASDAQ:NATH) is trading with a trailing P/E of 45.4x, which is higher than the industry average of 25.4x. While NATH might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 Nathan's Famous
What you need to know about the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 NATH
Price-Earnings Ratio = Price per share ÷ Earnings per share
NATH Price-Earnings Ratio = 74.5 ÷ 1.642 = 45.4x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to NATH, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since NATH's P/E of 45.4x is higher than its industry peers (25.4x), it means that investors are paying more than they should for each dollar of NATH's earnings. As such, our analysis shows that NATH represents an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your NATH shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to NATH. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with NATH, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing NATH to are fairly valued by the market. If this does not hold, there is a possibility that NATH’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 NATH. 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 NATH 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 Nathan's Famous 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.