AvalonBay Communities Inc (NYSE: AVB), a real estate firm with a market capitalization of $22.9 billion, currently trades at a P/E multiple of 29.4x which is below the sector’s median multiple of 31.4x. Although this makes AVB look attractive, investors may change their mind after reviewing the assumptions behind the P/E ratio. In the post below, I explain how to apply P/E multiples and what to watch out for.
How To Utilize AvalonBay’s PE Multiples
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 companies deemed to be similar. We can then determine if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
A P/E Ratio is a valuation metric that indicates the multiple of earnings investors are willing to pay for one share of a company:
P/E Ratio = Stock Price ÷ Earnings Per Share
The P/E ratio by itself is not very helpful at all. It is only useful when comparing it to other companies that are considered similar to the subject company. The basic idea is that companies with similar characteristics should trade at similar multiples, all other things being equal. Therefore, we can come to a conclusion about the stock if the ratios are different. In the chart below, I compare AvalonBay’s P/E ratio to its peer group that includes Equity Residential(NYSE: EQR), Essex Property Trust, Inc. (NYSE: ESS), Mid-America Apartment Communities, Inc. (NYSE: MAA) and UDR, Inc. (NYSE: UDR).
Since AvalonBay’s P/E ratio of 29.4x is lower than the median of its peers (42.0x), it means that investors are paying less than they should for each dollar of AVB’s earnings. As such, our analysis shows that AVB represents an undervalued stock. Furthermore, finbox.io’s P/E Ratio Model calculates a fair value of approximately $193.50 per share which implies roughly 16.5% upside.
I selected a fair multiple of 34.2x in my analysis by averaging AvalonBay’s current P/E ratio with its peer group.
The P/E Ratio’s Flaws
While this approach typically provides a reasonable valuation range, it is important to understand that our conclusion rests on some important assumptions. The first being that the selected peer group actually contains companies that truly are similar to AvalonBay. The second important assumption is that the selected peer group stocks are being fairly valued by the market.
If the assumptions above do not hold to be true, then the difference in P/E ratios could be due to a variety of factors. For example, if you accidentally compare AvalonBay with higher growth companies, then its P/E multiple would naturally be lower than its peers since investors reward high growth stocks with a higher price.
source: P/E model
On the other hand, if the second assumption does not hold true, AvalonBay’s lower multiple may be because our selected comparable companies are being overvalued by the market.
What To Do Next
As a current investor, you may have already conducted fundamental analysis on the company and its stock so its current undervaluation could signal a potential buying opportunity to increase your position in AVB. But keep in mind the P/E ratio’s potential flaws when applying this valuation approach. It is important to note that there are a variety of other fundamental factors that I have not taken into consideration in this article. I highly recommend that you continue your research on AvalonBay by taking a look at the following:
Valuation Metrics: what is AvalonBay’s free cash flow yield and how does it compare to its publicly traded peers? This metric measures the amount of free cash flow for each dollar of equity (market capitalization). Analyze the free cash flow yield here.
Risk Metrics: what is AvalonBay’s cash ratio which is used to assess a company’s short-term liquidity. View the company’s cash ratio here.
Efficiency Metrics: return on equity is used to measure the return that a firm generates on the book value of common equity. View AvalonBay’s return on equity here.
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.