Hershey Co (NYSE: HSY) trades at a P/E multiple of 25.8x, which is higher than the Consumer Staples sector median of 22.2x. While this makes HSY appear like a stock to avoid or sell if you own it, you might change your mind after gaining a better understanding of the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.

##### Understanding Valuation Multiples and the P/E Ratio

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 Hershey’s P/E multiple to those of ConAgra Brands, Inc. (NYSE: CAG), Campbell Soup Company (NYSE: CPB), Dean Foods Company (NYSE: DF) and Kellogg Company (NYSE: K) in the chart below.

Since Hershey’s P/E of 25.8x is higher than the median of its peers (14.7x), it means that investors are paying more than they should for each dollar of HSY’s earnings. As such, our analysis shows that HSY represents an overvalued stock. In fact, finbox.io’s P/E Multiple Model calculates a fair value of \$77.75 per share which implies -20.7% downside.

Note that the selected multiple of 20.9x in the analysis above was determined by averaging Hershey’s current P/E multiple with its peer group and sector.

##### Understanding the P/E Ratio’s Limitations

Before jumping to the conclusion that Hershey 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 Hershey, 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 Hershey 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, Hershey’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 HSY. 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 Hershey by taking a look at the following:

Risk Metrics: what is Hershey’s asset efficiency? This ratio measures the amount of cash flow that a company generates from its assets. View the company’s asset efficiency here.

Valuation Metrics: what is Hershey’s short ratio and how does it compare to its publicly traded peers? It represents the percentage of total shares outstanding that is being shorted. View the short ratio 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 Hershey’s inventory turnover here.

##### Author: Andy Pai

Expertise: financial modeling, mergers & acquisitions

Andy is also a founder at finbox.io, where he’s focused on building tools that make it faster and easier for investors to do investment research. Andy’s background is in investment banking where he led the analysis on over 50 board advisory engagements involving mergers and acquisitions, fairness opinions and solvency opinions. Some of his board advisory highlights:

• Sears Holdings Corp.’s \$620 mm spin-off via rights offering of Sears Outlet, Hometown Stores and Sears Hardware Stores.
• Cerberus Capital Management’s \$3.3 bn acquisition of SUPERVALU Inc.’s New Albertsons, Inc. assets.

Andy can be reached at andy@finbox.io.

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.

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