Advance Auto Parts, Inc. (NYSE: AAP) trades at a P/E multiple of 17.4x, which is lower than the Consumer Discretionary sector median of 18.9x. While this makes AAP appear like a stock to add to your portfolio, you might change your mind after gaining a better understanding of the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Understanding Valuation Multiples and the P/E Ratio
A Multiples Valuation, also known as a Comparable Companies Analysis, determines the value of a subject company by benchmarking the subject’s financial performance against similar public companies (Peer Group). We can infer if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
A P/E Multiple is a valuation ratio that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Multiple = Stock Price ÷ Earnings Per Share
The P/E ratio is not meant to be viewed in isolation and is only useful when comparing it to other similar companies. 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. I compare AAP’s P/E multiple to those of AutoZone, Inc. (NYSE: AZO), Lithia Motors, Inc. (NYSE: LAD), Asbury Automotive Group Inc (NYSE: ABG) and Sonic Automotive, Inc. (NYSE: SAH) in the chart below.
Since AAP’s P/E of 17.4x is higher than the median of its peers (10.2x), it means that investors are paying more than they should for each dollar of AAP’s earnings. As such, our analysis shows that AAP represents an overvalued stock. In fact, finbox.io’s P/E Multiple Modelcalculates a fair value of $76.49 per share which implies -31.7% downside.
Note that the selected multiple of 11.9x in the analysis above was determined by averaging AAP’s current P/E multiple with its peer group.
Understanding the P/E Ratio’s Limitations
Before jumping to the conclusion that AAP should be banished from your portfolio, it is important to understand that our conclusion rests on two important assumptions.
(1) the selected peer group actually contains companies that truly are similar to AAP, and
(2) the selected peer group stocks are being fairly valued by the market.
If the first assumption is not accurate, the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare AAP with lower growth companies, then its P/E multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price.
source: P/E model
Now if the second assumption does not hold true, AAP’s higher multiple may be because firms in our peer group are being undervalued by the market.
What This Means For Investors
As a shareholder, you may have already conducted fundamental analysis on the stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to AAP. However, keep in mind the limitations of the P/E ratio when making investment decisions. There are a variety of other fundamental factors that I have not taken into consideration in this article. If you have not done so already, I highly recommend that you complete your research on AAP by taking a look at the following:
Valuation Metrics: how much upside do shares of AAP have based on Wall Street’s consensus price target? Take a look at our analyst upside data explorer that compares the company’s upside relative to its peers.
Risk Metrics: what is AAP’s CapEx coverage? This is the amount a company outlays for capital assets for each dollar it generates from those investments. View the company’s CapEx coverage here.
Efficiency Metrics: is management becoming more or less efficient over time? Find out by analyzing the company’s asset turnover ratio which measures the dollars in revenue a company generates per dollar of assets.
Author: Matt Hogan
Expertise: Valuation, financial statement analysis
Matt Hogan is also a co-founder of finbox.io. His expertise is in investment decision making. Prior to finbox.io, Matt worked for an investment banking group providing fairness opinions in connection to stock acquisitions. He spent much of his time building valuation models to help clients determine an asset’s fair value. He believes that these same valuation models should be used by all investors before buying or selling a stock.
Matt can be reached at firstname.lastname@example.org.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.