Silicom Ltd (NASDAQ:SILC) is trading with a trailing P/E of 35.2x, which is higher than the industry average of 24.9x. While this makes SILC 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 break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Silicom
Breaking down the Price-Earnings 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 SILC
Price-Earnings Ratio = Price per share ÷ Earnings per share
SILC Price-Earnings Ratio = $75.4 ÷ $2.144 = 35.2x
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 SILC, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. At 35.2x, SILC’s P/E is higher than its industry peers (24.9x). This implies that investors are overvaluing each dollar of SILC’s earnings. Therefore, according to this analysis, SILC is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that SILC should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to SILC. 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 SILC, 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 SILC to are fairly valued by the market. If this does not hold, there is a possibility that SILC’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to SILC. 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.
Are you a potential investor? If you are considering investing in SILC, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
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 Silicom 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.