Shire plc (NASDAQ:SHPG) is trading with a trailing P/E of 12.1x, which is lower than the industry average of 27.3x. While this makes SHPG 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 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
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 SHPG
Price-Earnings Ratio = Price per share ÷ Earnings per share
SHPG Price-Earnings Ratio = $56.56 ÷ $4.692 = 12.1x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as SHPG, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since SHPG’s P/E of 12.1x is lower than its industry peers (27.3x), it means that investors are paying less than they should for each dollar of SHPG’s earnings. Therefore, according to this analysis, SHPG is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that SHPG is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to SHPG. 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 SHPG, 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 SHPG to are fairly valued by the market. If this does not hold, there is a possibility that SHPG’s P/E is lower because our peer group is 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 SHPG 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for SHPG’s future growth? Take a look at our free research report of analyst consensus for SHPG’s outlook.
- Past Track Record: Has SHPG 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 SHPG’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.