I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
HomeServe plc (LON:HSV) trades with a trailing P/E of 30.6, which is higher than the industry average of 22. 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
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 HSV
Price-Earnings Ratio = Price per share ÷ Earnings per share
HSV Price-Earnings Ratio = £9.24 ÷ £0.302 = 30.6x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to HSV, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. HSV’s P/E of 30.6 is higher than its industry peers (22), which implies that each dollar of HSV’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 24 Commercial Services companies in GB including Mortice, Communisis and Babcock International Group. You could think of it like this: the market is pricing HSV as if it is a stronger company than the average of its industry group.
A few caveats
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to HSV. If not, the difference in P/E might be a result of other factors. For example, HomeServe plc could be growing more quickly than the companies we’re comparing it with. In that case it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with HSV are not 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:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in HSV. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. 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 HSV’s future growth? Take a look at our free research report of analyst consensus for HSV’s outlook.
- Past Track Record: Has HSV 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 HSV’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 email@example.com.