Scottish Pacific Group Limited (ASX:SCO) is trading with a trailing P/E of 21.6x, which is higher than the industry average of 17x. While SCO might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, 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 Scottish Pacific Group
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for relative valuation. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for SCO
Price per share = A$3.2
Earnings per share = A$0.148
∴ Price-Earnings Ratio = A$3.2 ÷ A$0.148 = 21.6x
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. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to SCO, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
Since SCO’s P/E of 21.6x is higher than its industry peers (17x), it means that investors are paying more than they should for each dollar of SCO’s earnings. As such, our analysis shows that SCO represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your SCO shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to SCO. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared riskier firms with SCO, then investors would naturally value SCO at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with SCO, investors would also value SCO at a higher price since it is a higher growth investment. Both scenarios would explain why SCO has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing SCO to are fairly valued by the market. If this assumption does not hold true, SCO’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to SCO. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 SCO’s future growth? Take a look at our free research report of analyst consensus for SCO’s outlook.
2. Financial Health: Is SCO’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
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.