Visa Inc (NYSE:V) is currently trading at a trailing P/E of 40.2x, which is higher than the industry average of 23.7x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. In this article, 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 Visa

Breaking down the Price-Earnings 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.

P/E Calculation for V

Price-Earnings Ratio = Price per share ÷ Earnings per share

V Price-Earnings Ratio = $121.27 ÷ $3.016 = 40.2x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as V, 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 V’s P/E of 40.2x is higher than its industry peers (23.7x), it means that investors are paying more than they should for each dollar of V’s earnings. As such, our analysis shows that V represents an over-priced stock.

A few caveats

Before you jump to the conclusion that V should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to V. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with V, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing V to are fairly valued by the market. If this does not hold true, V’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

Since you may have already conducted your due diligence on V, 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:

1. Future Outlook: What are well-informed industry analysts predicting for V’s future growth? Take a look at our free research report of analyst consensus for V’s outlook.

2. Past Track Record: Has V 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 V’s historicals for more clarity.

3. 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.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.