American Campus Communities Inc (NYSE:ACC) is trading with a trailing P/E of 105.5x, which is higher than the industry average of 33.4x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for American Campus Communities

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.

P/E Calculation for ACC

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

ACC Price-Earnings Ratio = 42.37 ÷ 0.402 = 105.5x

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 ACC, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since ACC’s P/E of 105.5x is higher than its industry peers (33.4x), it means that investors are paying more than they should for each dollar of ACC’s earnings. As such, our analysis shows that ACC represents an over-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that ACC 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 ACC. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with ACC, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing ACC to are fairly valued by the market. If this does not hold, there is a possibility that ACC’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to ACC. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.