ALLETE Inc (NYSE:ALE) is trading with a trailing P/E of 21.4x, which is higher than the industry average of 14x. While ALE 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. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for ALLETE
Demystifying the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for ALE
Price per share = $73.01
Earnings per share = $3.412
∴ Price-Earnings Ratio = $73.01 ÷ $3.412 = 21.4x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as ALE, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
At 21.4x, ALE’s P/E is higher than its industry peers (14x). This implies that investors are overvaluing each dollar of ALE’s earnings. Therefore, according to this analysis, ALE is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your ALE shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to ALE. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing riskier firms with ALE, then ALE’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with ALE. In this case, ALE’s P/E would be higher since investors would also reward ALE’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing ALE to are fairly valued by the market. If this assumption is violated, ALE’s P/E may be higher than its peers because its peers are actually undervalued 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 ALE. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for ALE’s future growth? Take a look at our free research report of analyst consensus for ALE’s outlook.
- Past Track Record: Has ALE 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 ALE’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.
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