Rolls-Royce Holdings plc (LSE:RR.) is trading with a trailing P/E of 3.8x, which is lower than the industry average of 20.8x. While this makes RR. appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. 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. View our latest analysis for Rolls-Royce Holdings
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in 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 pound of the company’s earnings.
P/E Calculation for RR.
Price-Earnings Ratio = Price per share ÷ Earnings per share
RR. Price-Earnings Ratio = £8.66 ÷ £2.294 = 3.8x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as RR., 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 RR.’s P/E of 3.8x is lower than its industry peers (20.8x), it means that investors are paying less than they should for each dollar of RR.’s earnings. Therefore, according to this analysis, RR. is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy RR., it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to RR., or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with RR., 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 RR. to are fairly valued by the market. If this does not hold true, RR.’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to RR.. 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. 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:
- Future Outlook: What are well-informed industry analysts predicting for RR.’s future growth? Take a look at our free research report of analyst consensus for RR.’s outlook.
- Past Track Record: Has RR. 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 RR.’s historicals for more clarity.
- 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.