The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Electrocomponents plc (LON:ECM) is trading with a trailing P/E of 21.5, which is higher than the industry average of 18. Although some investors may see this as unappealing, it is important to understand the assumptions behind the P/E ratio before making judgments. 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 Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 ECM
Price-Earnings Ratio = Price per share ÷ Earnings per share
ECM Price-Earnings Ratio = £7.3 ÷ £0.339 = 21.5x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to ECM, 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 ECM’s P/E of 21.5 is higher than its industry peers (18), it means that investors are paying more for each dollar of ECM’s earnings. This multiple is a median of profitable companies of 22 Electronic companies in GB including UniVision Engineering, Spectris and Image Scan Holdings. You could also say that the market is suggesting that ECM is a stronger business than the average comparable company.
Assumptions to be aware of
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. Firstly, that our peer group contains companies that are similar to ECM. If this isn’t the case, the difference in P/E could be due to other factors. Take, for example, the scenario where Electrocomponents 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. We should also be aware that the stocks we are comparing to ECM may not be fairly valued. Thus while we might conclude that it is richly valued relative to its peers, that could be explained by the peer group being undervalued.
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 ECM. 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 ECM’s future growth? Take a look at our free research report of analyst consensus for ECM’s outlook.
- Past Track Record: Has ECM 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 ECM’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 email@example.com.