The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
discoverIE Group plc (LON:DSCV) trades with a trailing P/E of 25.5, which is higher than the industry average of 17.6. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
Breaking down 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 DSCV
Price-Earnings Ratio = Price per share ÷ Earnings per share
DSCV Price-Earnings Ratio = £4.25 ÷ £0.167 = 25.5x
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 DSCV, 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 DSCV’s P/E of 25.5 is higher than its industry peers (17.6), it means that investors are paying more for each dollar of DSCV’s earnings. This multiple is a median of profitable companies of 21 Electronic companies in GB including Image Scan Holdings, Spectris and UniVision Engineering. You could also say that the market is suggesting that DSCV is a stronger business than the average comparable company.
A few caveats
However, you should be aware that this analysis makes certain assumptions. The first is that our “similar companies” are actually similar to DSCV. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where discoverIE Group plc is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. We should also be aware that the stocks we are comparing to DSCV may not be fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.
What this means for you:
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 DSCV. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for DSCV’s future growth? Take a look at our free research report of analyst consensus for DSCV’s outlook.
- Past Track Record: Has DSCV 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 DSCV’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 past 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. For errors that warrant correction please contact the editor at firstname.lastname@example.org.