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Should You Be Tempted To Buy Stornoway Diamond Corporation (TSX:SWY) Because Of Its PE Ratio?

Stornoway Diamond Corporation (TSX:SWY) trades with a trailing P/E of 17.3x, which is lower than the industry average of 38.1x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for SWY

Demystifying the P/E ratio

TSX:SWY PE PEG Gauge Sep 12th 17
TSX:SWY PE PEG Gauge Sep 12th 17

P/E is a popular ratio used for relative valuation. 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.

Formula

Price-Earnings Ratio = Price per share ÷ Earnings per share

P/E Calculation for SWY

Price per share = 0.75

Earnings per share = 0.043

∴ Price-Earnings Ratio = 0.75 ÷ 0.043 = 17.3x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as SWY, 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 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 17.3x, SWY’s P/E is lower than its industry peers (38.1x). This implies that investors are undervaluing each dollar of SWY’s earnings. Therefore, according to this analysis, SWY is an under-priced stock.

Assumptions to watch out for

Before you jump to the conclusion that SWY represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to SWY. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared lower risk firms with SWY, then investors would naturally value SWY at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with SWY, investors would also value SWY at a lower price since it is a lower growth investment. Both scenarios would explain why SWY has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing SWY to are fairly valued by the market. If this assumption does not hold true, SWY’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.

TSX:SWY Future Profit Sep 12th 17
TSX:SWY Future Profit Sep 12th 17

What this means for you:

Are you a shareholder? 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 SWY 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.

Are you a potential investor? If you are considering investing in SWY, 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 Stornoway Diamond 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.

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