This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
dotDigital Group Plc (LON:DOTD) is trading with a trailing P/E of 37.6, which is higher than the industry average of 35.8. Though this might seem to be a negative, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
Breaking down the P/E ratio
P/E is a popular ratio used for 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 DOTD
Price-Earnings Ratio = Price per share ÷ Earnings per share
DOTD Price-Earnings Ratio = £0.95 ÷ £0.0253 = 37.6x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 DOTD, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since DOTD’s P/E of 37.6 is higher than its industry peers (35.8), it means that investors are paying more for each dollar of DOTD’s earnings. This multiple is a median of profitable companies of 24 Software companies in GB including Team17 Group, Petards Group and Micro Focus International. You could also say that the market is suggesting that DOTD is a stronger business than the average comparable company.
A few caveats
However, you should be aware that this analysis makes certain assumptions. The first is that our “similar companies” are actually similar to DOTD. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where dotDigital Group Plc is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with DOTD are not fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
What this means for you:
Since you may have already conducted your due diligence on DOTD, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for DOTD’s future growth? Take a look at our free research report of analyst consensus for DOTD’s outlook.
- Past Track Record: Has DOTD 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 DOTD’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 firstname.lastname@example.org.