Daily Journal Corporation (NASDAQ:DJCO) trades with a trailing P/E of 21.2x, which is higher than the industry average of 16x. While DJCO 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 break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Daily Journal
Breaking down 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for DJCO
Price per share = $234.7
Earnings per share = $11.075
∴ Price-Earnings Ratio = $234.7 ÷ $11.075 = 21.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to DJCO, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
At 21.2x, DJCO’s P/E is higher than its industry peers (16x). This implies that investors are overvaluing each dollar of DJCO’s earnings. As such, our analysis shows that DJCO represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your DJCO shares immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to DJCO. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared lower growth firms with DJCO, then DJCO’s P/E would naturally be higher since investors would reward DJCO’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with DJCO, DJCO’s P/E would again be higher since investors would reward DJCO’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing DJCO to are fairly valued by the market. If this assumption does not hold true, DJCO’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:
Since you may have already conducted your due diligence on DJCO, 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:
- Financial Health: Is DJCO’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 DJCO 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 DJCO’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.
Warren Buffet’s Portfolio: What is he holding?
Get insight into the mind of the most renowned value investor on the planet. Take a look at the portfolio’s top holdings, past performance, how he diversifies his investments, growth estimates and explore investment ideas based on Buffet’s investing methodology. Click here to view a FREE infographic analysis of Warren Buffet’s investment portfolio.
This post was originally published on *this site*