Shire plc (LSE:SHP) trades with a trailing P/E of 65.3x, which is higher than the industry average of 36.1x. While this makes SHP appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Shire
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 pound of the company’s earnings.
P/E Calculation for SHP
Price-Earnings Ratio = Price per share ÷ Earnings per share
SHP Price-Earnings Ratio = 37.78 ÷ 0.778 = 65.3x
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 SHP, 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 SHP's P/E of 65.3x is higher than its industry peers (36.1x), it means that investors are paying more than they should for each dollar of SHP's earnings. Therefore, according to this analysis, SHP is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that SHP should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to SHP, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with SHP, 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 SHP to are fairly valued by the market. If this is violated, SHP's P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on SHP, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.
Are you a potential investor? If you are considering investing in SHP, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Shire for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
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.