I am writing today to help inform people who are new to the stock market and want to begin learning the link between Vector Limited (NZSE:VCT)’s fundamentals and stock market performance.
Vector Limited (NZSE:VCT) trades with a trailing P/E of 24.1x, which is higher than the industry average of 17.3x. While this makes VCT 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. Check out our latest analysis for Vector
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in 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 VCT
Price-Earnings Ratio = Price per share ÷ Earnings per share
VCT Price-Earnings Ratio = NZ$3.38 ÷ NZ$0.140 = 24.1x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 VCT, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. VCT’s P/E of 24.1x is higher than its industry peers (17.3x), which implies that each dollar of VCT’s earnings is being overvalued by investors. Therefore, according to this analysis, VCT is an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your VCT shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to VCT. 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 VCT, 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 VCT to are fairly valued by the market. If this is violated, VCT’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
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 VCT. 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. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for VCT’s future growth? Take a look at our free research report of analyst consensus for VCT’s outlook.
- Past Track Record: Has VCT 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 VCT’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.