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 learn about the link between company’s fundamentals and stock market performance.
Rentokil Initial plc (LON:RTO) is currently trading at a trailing P/E of 31.5, which is higher than the industry average of 22.5. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
What you need to know about 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 RTO
Price-Earnings Ratio = Price per share ÷ Earnings per share
RTO Price-Earnings Ratio = £3.25 ÷ £0.103 = 31.5x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 RTO, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since RTO’s P/E of 31.5 is higher than its industry peers (22.5), it means that investors are paying more for each dollar of RTO’s earnings. 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 RTO as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
However, it is important to note that our examination of the stock is based on certain assumptions. Firstly, that our peer group contains companies that are similar to RTO. If this isn’t the case, the difference in P/E could be due to other factors. Take, for example, the scenario where Rentokil Initial 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. Of course, it is possible that the stocks we are comparing with RTO are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be 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 RTO. 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 RTO’s future growth? Take a look at our free research report of analyst consensus for RTO’s outlook.
- Past Track Record: Has RTO 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 RTO’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.