I am writing today to help inform people who are new to the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Sonoco Products Company (NYSE:SON) is currently trading at a trailing P/E of 22.5, which is higher than the industry average of 21.4. 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 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 SON
Price-Earnings Ratio = Price per share ÷ Earnings per share
SON Price-Earnings Ratio = $54.35 ÷ $2.41 = 22.5x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SON, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. SON’s P/E of 22.5 is higher than its industry peers (21.4), which implies that each dollar of SON’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 15 Packaging companies in US including WestRock, International Paper and Silgan Holdings. You could think of it like this: the market is pricing SON as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
However, you should be aware that this analysis makes certain assumptions. The first is that our “similar companies” are actually similar to SON. If not, the difference in P/E might be a result of other factors. For example, Sonoco Products Company could be growing more quickly than the companies we’re comparing it with. In that case it would deserve a higher P/E ratio. Of course, it is possible that the stocks we are comparing with SON are not fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.
What this means for you:
Since you may have already conducted your due diligence on SON, 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:
- Future Outlook: What are well-informed industry analysts predicting for SON’s future growth? Take a look at our free research report of analyst consensus for SON’s outlook.
- Past Track Record: Has SON 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 SON’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.