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Should You Be Tempted To Sell Ricardo plc (LON:RCDO) At Its Current PE Ratio?

This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between Ricardo plc (LON:RCDO)’s fundamentals and stock market performance.

Ricardo plc (LON:RCDO) trades with a trailing P/E of 22x, which is higher than the industry average of 18.5x. While this makes RCDO 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.

What you need to know about the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 RCDO

Price-Earnings Ratio = Price per share ÷ Earnings per share

RCDO Price-Earnings Ratio = £10.05 ÷ £0.456 = 22x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as RCDO, 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. At 22x, RCDO’s P/E is higher than its industry peers (18.5x). This implies that investors are overvaluing each dollar of RCDO’s earnings. As such, our analysis shows that RCDO represents an over-priced stock.

Assumptions to be aware of

However, before you rush out to sell your RCDO shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to RCDO, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with RCDO, 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 RCDO to are fairly valued by the market. If this does not hold, there is a possibility that RCDO’s P/E is lower because our peer group is overvalued by the market.

What this means for you:

Since you may have already conducted your due diligence on RCDO, 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 urge you to complete your research by taking a look at the following:

1. Future Outlook: What are well-informed industry analysts predicting for RCDO’s future growth? Take a look at our free research report of analyst consensus for RCDO’s outlook.
2. Past Track Record: Has RCDO 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 RCDO’s historicals for more clarity.
3. 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.