Digi International Inc (NASDAQ:DGII) trades with a trailing P/E of 124.7x, which is higher than the industry average of 28.7x. While this makes DGII 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. 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 Digi International
Breaking down the P/E ratio
The P/E ratio is one of many ratios used in 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.
P/E Calculation for DGII
Price-Earnings Ratio = Price per share ÷ Earnings per share
DGII Price-Earnings Ratio = $11.45 ÷ $0.092 = 124.7x
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 DGII, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since DGII’s P/E of 124.7x is higher than its industry peers (28.7x), it means that investors are paying more than they should for each dollar of DGII’s earnings. As such, our analysis shows that DGII represents an over-priced stock.
Assumptions to be aware of
While our conclusion might prompt you to sell your DGII shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to DGII, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with DGII, 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 DGII to are fairly valued by the market. If this is violated, DGII’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in DGII. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above. 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 DGII’s future growth? Take a look at our free research report of analyst consensus for DGII’s outlook.
- Past Track Record: Has DGII 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 DGII’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 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.