Dragon Victory International Limited (NASDAQ:LYL) is trading with a trailing P/E of 79.8x, which is higher than the industry average of 40.4x. While LYL might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Dragon Victory International

Breaking down the Price-Earnings ratio

P/E is a popular ratio used for relative valuation. 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 LYL

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

LYL Price-Earnings Ratio = 13.67 ÷ 0.171 = 79.8x

On its own, the P/E ratio doesn't tell you much; however, it becomes extremely useful when you compare it with other similar companies. We preferably want to compare the stock's P/E ratio to the average of companies that have similar features to LYL, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I'll do. Since LYL's P/E of 79.8x is higher than its industry peers (40.4x), it means that investors are paying more than they should for each dollar of LYL's earnings. As such, our analysis shows that LYL represents an over-priced stock.

A few caveats

However, before you rush out to sell your LYL shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to LYL. 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 LYL, 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 LYL to are fairly valued by the market. If this is violated, LYL's P/E may be lower than its peers as they are actually overvalued by investors.

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 LYL. 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.