I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Silver Chef Limited (ASX:SIV) is currently trading at a trailing P/E of 36.5x, which is higher than the industry average of 19x. While this makes SIV 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.
What you need to know about the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for SIV
Price per share = A$2.48
Earnings per share = A$0.0680
∴ Price-Earnings Ratio = A$2.48 ÷ A$0.0680 = 36.5x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against 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 SIV, 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 36.5x, SIV’s P/E is higher than its industry peers (19x). This implies that investors are overvaluing each dollar of SIV’s earnings. This multiple is a median of profitable companies of 5 Trade Distributors companies in AU including Spicers, HGL and Legend. As such, our analysis shows that SIV represents an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that SIV should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to SIV. 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 SIV, then investors would naturally value SIV at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with SIV, investors would also value SIV at a higher price since it is a higher growth investment. Both scenarios would explain why SIV has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing SIV to are fairly valued by the market. If this assumption does not hold true, SIV’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in SIV. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 SIV’s future growth? Take a look at our free research report of analyst consensus for SIV’s outlook.
- Past Track Record: Has SIV 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 SIV’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 email@example.com.