This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
The Hackett Group Inc (NASDAQ:HCKT) is trading with a trailing P/E of 17.3x, which is lower than the industry average of 26.4x. While this makes HCKT appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Demystifying 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 HCKT
Price-Earnings Ratio = Price per share ÷ Earnings per share
HCKT Price-Earnings Ratio = $20.09 ÷ $1.159 = 17.3x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to HCKT, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. HCKT’s P/E of 17.3 is lower than its industry peers (26.4), which implies that each dollar of HCKT’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 IT companies in US including e-Synergies, Bitfarms Technologies and Fintech Select. One could put it like this: the market is pricing HCKT as if it is a weaker company than the average company in its industry.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to HCKT, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with HCKT, 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 HCKT to are fairly valued by the market. If this does not hold, there is a possibility that HCKT’s P/E is lower because our peer group is overvalued by the market.
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 HCKT. 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 HCKT’s future growth? Take a look at our free research report of analyst consensus for HCKT’s outlook.
- Past Track Record: Has HCKT 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 HCKT’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.