O’Reilly Automotive Inc (NASDAQ: ORLY) trades at a P/E multiple of 17.4x, which is lower than the Consumer Discretionary sector median of 18.9x. While this makes ORLY 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 O’Reilly Automotive’s P/E multiple to those of Advance Auto Parts Inc (NYSE: AAP), AutoZone, Inc.(NYSE: AZO), Lithia Motors, Inc. (NYSE: LAD) and Asbury Automotive Group Inc (NYSE: ABG) in the chart below.
Since O’Reilly Automotive’s P/E of 17.4x is higher than the median of its peers (11.7x), it means that investors are paying more than they should for each dollar of ORLY’s earnings. As such, our analysis shows that ORLY represents an overvalued stock. In fact, finbox.io’s P/E Multiple Model calculates a fair value of $185.11 per share which implies -22.0% downside.
Note that the selected multiple of 13.6x in the analysis above was determined by averaging O’Reilly Automotive’s current P/E multiple with its peer group.
Understanding the P/E Ratio’s Limitations
Before jumping to the conclusion that O’Reilly Automotive 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 O’Reilly Automotive, 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 O’Reilly Automotive 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, O’Reilly Automotive’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 ORLY. 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 O’Reilly Automotive by taking a look at the following:
Forecast Metrics: what is O’Reilly Automotive’s projected earnings growth? Is the company expected to grow faster or slower relative to its peers? Analyze the company’s projected earnings growth here.
Efficiency Metrics: how much free cash flow does O’Reilly Automotive generate as a percentage of total sales? Has it been increasing or decreasing over time? Review the firm’s free cash flow margin here.
Risk Metrics: what is O’Reilly Automotive’s asset efficiency? This ratio measures the amount of cash flow that a company generates from its assets. View the company’s asset efficiency here.
Author: Andy Pai
Expertise: financial modeling, mergers & acquisitions
Andy is also a founder at finbox.io, where he’s focused on building tools that make it faster and easier for investors to do investment research. Andy’s background is in investment banking where he led the analysis on over 50 board advisory engagements involving mergers and acquisitions, fairness opinions and solvency opinions. Some of his board advisory highlights:
- Sears Holdings Corp.’s $620 mm spin-off via rights offering of Sears Outlet, Hometown Stores and Sears Hardware Stores.
- Cerberus Capital Management’s $3.3 bn acquisition of SUPERVALU Inc.’s New Albertsons, Inc. assets.
Andy can be reached at email@example.com.
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.