Valhi Inc (NYSE:VHI) is trading with a trailing P/E of 6.3x, which is lower than the industry average of 17.3x. Although some investors may jump to the conclusion that this is a great buying opportunity, 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 Valhi
What you need to know about the P/E ratio
P/E is a popular ratio used for relative valuation. 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 VHI
Price-Earnings Ratio = Price per share ÷ Earnings per share
VHI Price-Earnings Ratio = $6.5 ÷ $1.035 = 6.3x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to VHI, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 6.3x, VHI’s P/E is lower than its industry peers (17.3x). This implies that investors are undervaluing each dollar of VHI’s earnings. Therefore, according to this analysis, VHI is an under-priced stock.
A few caveats
Before you jump to the conclusion that VHI is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to VHI. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with VHI, 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 VHI to are fairly valued by the market. If this does not hold true, VHI’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 VHI, the undervaluation of the stock may mean it is a good time to top up on 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:
- Financial Health: Is VHI’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 VHI 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 VHI’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.