This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.
Xenith IP Group Limited (ASX:XIP) trades with a trailing P/E of 23.1x, which is higher than the industry average of 21.6x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. 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
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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for XIP
Price per share = A$1.18
Earnings per share = A$0.0508
∴ Price-Earnings Ratio = A$1.18 ÷ A$0.0508 = 23.1x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to XIP, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. 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 23.1x, XIP’s P/E is higher than its industry peers (21.6x). This implies that investors are overvaluing each dollar of XIP’s earnings. This multiple is a median of profitable companies of 12 Professional Services companies in AU including Energy Action, Qantm Intellectual Property and Ashley Services Group. Therefore, according to this analysis, XIP is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that XIP should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to XIP. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with XIP, then investors would naturally value XIP at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with XIP, investors would also value XIP at a higher price since it is a higher growth investment. Both scenarios would explain why XIP has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing XIP to are fairly valued by the market. If this assumption is violated, XIP’s P/E may be higher than its peers because its peers are actually undervalued by investors.
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 XIP. 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for XIP’s future growth? Take a look at our free research report of analyst consensus for XIP’s outlook.
- Financial Health: Is XIP’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.
- 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. For errors that warrant correction please contact the editor at firstname.lastname@example.org.