Nordstrom, Inc. (NYSE: JWN) trades at a P/E multiple of 16.9x, which is lower than the Consumer Discretionary sector median of 19.3x. While this makes JWN appear like a stock to add to your portfolio, you might change your mind after comparing the company to its peers. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
How To Utilize 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 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 Nordstrom's P/E multiple to those of Kohl's Corporation (NYSE: KSS), Gap, Inc. (NYSE: GPS), Macy's Inc (NYSE: M) and L Brands, Inc. (NYSE: LB) in the chart below.
Since Nordstrom's P/E of 16.9x is higher than the median of its peers (13.7x), it means that investors are paying more than they should for each dollar of JWN's earnings. As such, our analysis shows that JWN represents an overvalued stock. In fact, finbox.io's P/E Multiple Model calculates a fair value of $42.37 per share which implies -14.1% downside.
Note that the selected multiple of 14.5x in the analysis above was determined by averaging Nordstrom's current P/E multiple with its peer group.
Understanding the P/E Ratio's Limitations
Before jumping to the conclusion that Nordstrom 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 Nordstrom, 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 Nordstrom 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, Nordstrom'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 JWN. 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 Nordstrom by taking a look at the following:
Valuation Metrics: what is Nordstrom'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.
Efficiency Metrics: inventory turnover is a ratio that measures the number of times a company's inventory is sold and replaced over the year. View Nordstrom's inventory turnover here.
Forecast Metrics: what is Nordstrom'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.
Article by Andy Pai, Finbox.io