The Scottish Investment Trust PLC (LSE:SCIN) is trading with a trailing P/E of 10.9x, which is lower than the industry average of 16.6x. While this makes SCIN appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Scottish Investment Trust
Breaking down the P/E ratio
P/E is a popular ratio used for relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each pound of the company’s earnings.
P/E Calculation for SCIN
Price-Earnings Ratio = Price per share ÷ Earnings per share
SCIN Price-Earnings Ratio = £8.2 ÷ £0.755 = 10.9x
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 SCIN, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since SCIN’s P/E of 10.9x is lower than its industry peers (16.6x), it means that investors are paying less than they should for each dollar of SCIN’s earnings. Therefore, according to this analysis, SCIN is an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy SCIN, 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 SCIN, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with SCIN, 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 SCIN to are fairly valued by the market. If this is violated, SCIN’s P/E may be lower than its peers as they are actually overvalued by investors.
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.