Innovative Solutions and Support Inc (NASDAQ:ISSC) trades with a trailing P/E of 10.5x, which is lower than the industry average of 22.3x. While this makes ISSC 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Innovative Solutions and Support
What you need to know about the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 ISSC
Price-Earnings Ratio = Price per share ÷ Earnings per share
ISSC Price-Earnings Ratio = $3.06 ÷ $0.291 = 10.5x
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 ISSC, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. ISSC’s P/E of 10.5x is lower than its industry peers (22.3x), which implies that each dollar of ISSC’s earnings is being undervalued by investors. Therefore, according to this analysis, ISSC is an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy ISSC, 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 ISSC, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with ISSC, 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 ISSC to are fairly valued by the market. If this does not hold true, ISSC’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of ISSC to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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:
- Financial Health: Is ISSC’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has ISSC 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 ISSC’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.