Versum Materials Inc (NYSE:VSM) trades with a trailing P/E of 23.5x, which is lower than the industry average of 24.5x. While this makes VSM 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 break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Versum Materials
Demystifying 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 VSM
Price-Earnings Ratio = Price per share ÷ Earnings per share
VSM Price-Earnings Ratio = $38.38 ÷ $1.631 = 23.5x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as VSM, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. VSM’s P/E of 23.5x is lower than its industry peers (24.5x), which implies that each dollar of VSM’s earnings is being undervalued by investors. Therefore, according to this analysis, VSM is an under-priced stock.
A few caveats
However, before you rush out to buy VSM, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to VSM. 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 VSM, 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 VSM to are fairly valued by the market. If this does not hold true, VSM’s lower P/E ratio may be because firms in our peer group are 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 VSM. 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 VSM’s future growth? Take a look at our free research report of analyst consensus for VSM’s outlook.
- Financial Health: Is VSM’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- 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.