This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Spectris plc (LON:SXS) is trading with a trailing P/E of 9.5x, which is lower than the industry average of 17.2x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
What you need to know about 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. 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 dollar of the company’s earnings.
P/E Calculation for SXS
Price-Earnings Ratio = Price per share ÷ Earnings per share
SXS Price-Earnings Ratio = £23.15 ÷ £2.449 = 9.5x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SXS, 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. SXS’s P/E of 9.5 is lower than its industry peers (17.2), which implies that each dollar of SXS’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 23 Electronic companies in GB including Trackwise Designs, Image Scan Holdings and UniVision Engineering. One could put it like this: the market is pricing SXS as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
However, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to SXS. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with SXS, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing SXS to are fairly valued by the market. If this is violated, SXS’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to SXS. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for SXS’s future growth? Take a look at our free research report of analyst consensus for SXS’s outlook.
- Past Track Record: Has SXS 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 SXS’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.