Unilever PLC (LSE:ULVR) is trading with a trailing P/E of 20.8x, which is higher than the industry average of 16.7x. 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. See our latest analysis for Unilever
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 pound of the company’s earnings.
P/E Calculation for ULVR
Price-Earnings Ratio = Price per share ÷ Earnings per share
ULVR Price-Earnings Ratio = €44.99 ÷ €2.161 = 20.8x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ULVR, 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. At 20.8x, ULVR’s P/E is higher than its industry peers (16.7x). This implies that investors are overvaluing each dollar of ULVR’s earnings. As such, our analysis shows that ULVR represents an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your ULVR shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to ULVR, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with ULVR, 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 ULVR to are fairly valued by the market. If this does not hold true, ULVR’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on ULVR, 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. 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:
- Future Outlook: What are well-informed industry analysts predicting for ULVR’s future growth? Take a look at our free research report of analyst consensus for ULVR’s outlook.
- Past Track Record: Has ULVR 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 ULVR’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.