Mercia Technologies PLC (AIM:MERC) is currently trading at a trailing P/E of 69.2x, which is higher than the industry average of 16.4x. While this makes MERC 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. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Mercia Technologies
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. 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 pound of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for MERC
Price per share = 0.32
Earnings per share = 0.005
∴ Price-Earnings Ratio = 0.32 ÷ 0.005 = 69.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to MERC, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
At 69.2x, MERC’s P/E is higher than its industry peers (16.4x). This implies that investors are overvaluing each dollar of MERC’s earnings. As such, our analysis shows that MERC represents an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your MERC shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to MERC. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing riskier firms with MERC, then MERC’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with MERC. In this case, MERC’s P/E would be higher since investors would also reward MERC’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing MERC to are fairly valued by the market. If this does not hold, there is a possibility that MERC’s P/E is higher because firms in our peer group are being undervalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on MERC, 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.
Are you a potential investor? If you are considering investing in MERC, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Mercia Technologies for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.