Power Integrations Inc (NASDAQ:POWI) is trading with a trailing P/E of 70.8x, which is higher than the industry average of 24.3x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Power Integrations
Breaking down the P/E 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 POWI
Price-Earnings Ratio = Price per share ÷ Earnings per share
POWI Price-Earnings Ratio = $65.9 ÷ $0.93 = 70.8x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to POWI, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since POWI’s P/E of 70.8x is higher than its industry peers (24.3x), it means that investors are paying more than they should for each dollar of POWI’s earnings. As such, our analysis shows that POWI represents an over-priced stock.
A few caveats
Before you jump to the conclusion that POWI should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to POWI. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with POWI, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing POWI to are fairly valued by the market. If this does not hold true, POWI’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on POWI, 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 POWI’s future growth? Take a look at our free research report of analyst consensus for POWI’s outlook.
- Past Track Record: Has POWI 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 POWI’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.