Does Pearson plc’s (LON:PSON) PE Ratio Signal A Buying Opportunity?
Pearson plc (LSE:PSON) trades with a trailing P/E of 18.5x, which is lower than the industry average of 20.9x. 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Pearson
What you need to know about the P/E ratio
P/E is a popular ratio used for 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 PSON
Price-Earnings Ratio = Price per share ÷ Earnings per share
PSON Price-Earnings Ratio = £9.21 ÷ £0.499 = 18.5x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to PSON, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since PSON’s P/E of 18.5x is lower than its industry peers (20.9x), it means that investors are paying less than they should for each dollar of PSON’s earnings. As such, our analysis shows that PSON represents an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy PSON, 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 PSON, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with PSON, 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 PSON to are fairly valued by the market. If this is violated, PSON’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on PSON, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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 highly recommend you to complete your research by taking a look at the following:
Future Outlook: What are well-informed industry analysts predicting for PSON’s future growth? Take a look at our free research report of analyst consensus for PSON’s outlook.
Past Track Record: Has PSON 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 PSON’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.
