Sky Solar Holdings Ltd (NASDAQ:SKYS) is trading with a trailing P/E of 18.3x, which is lower than the industry average of 45.1x. While SKYS 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. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Sky Solar Holdings
Breaking down the Price-Earnings 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 dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for SKYS
Price per share = 1.38
Earnings per share = 0.075
∴ Price-Earnings Ratio = 1.38 ÷ 0.075 = 18.3x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to SKYS, 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. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
At 18.3x, SKYS’s P/E is lower than its industry peers (45.1x). This implies that investors are undervaluing each dollar of SKYS’s earnings. As such, our analysis shows that SKYS represents an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy SKYS immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to SKYS. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared higher growth firms with SKYS, then SKYS’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with SKYS, SKYS’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing SKYS to are fairly valued by the market. If this does not hold, there is a possibility that SKYS’s P/E is lower because firms in our peer group are being 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 undervaluation could signal a good buying opportunity to increase your exposure to SKYS. 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 SKYS, 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 Sky Solar Holdings 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.