This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Simulations Plus Inc (NASDAQ:SLP) is currently trading at a trailing P/E of 39.5x, which is lower than the industry average of 55.6x. While SLP might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 SLP
Price-Earnings Ratio = Price per share ÷ Earnings per share
SLP Price-Earnings Ratio = $19.99 ÷ $0.506 = 39.5x
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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SLP, 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. SLP’s P/E of 39.5 is lower than its industry peers (55.6), which implies that each dollar of SLP’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 11 Healthcare Services companies in US including MedLink International, DATATRAK International and Cerner. One could put it like this: the market is pricing SLP as if it is a weaker company than the average company in its industry.
A few caveats
However, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to SLP, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with SLP, 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 SLP to are fairly valued by the market. If this does not hold, there is a possibility that SLP’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 SLP. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for SLP’s future growth? Take a look at our free research report of analyst consensus for SLP’s outlook.
- Past Track Record: Has SLP 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 SLP’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 email@example.com.