LSI Software SA. (WSE:LSI) trades with a trailing P/E of 9.2x, which is lower than the industry average of 27.4x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for LSI Software
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 LSI
Price-Earnings Ratio = Price per share ÷ Earnings per share
LSI Price-Earnings Ratio = PLN13.5 ÷ PLN1.469 = 9.2x
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 LSI, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. LSI’s P/E of 9.2x is lower than its industry peers (27.4x), which implies that each dollar of LSI’s earnings is being undervalued by investors. As such, our analysis shows that LSI represents an under-priced stock.
A few caveats
However, before you rush out to buy LSI, 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 LSI, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with LSI, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing LSI to are fairly valued by the market. If this does not hold true, LSI’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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.