Superloop Limited (ASX:SLC) trades with a trailing P/E of 191x, which is higher than the industry average of 21x. 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. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. View our latest analysis for Superloop
Breaking down the Price-Earnings ratio
The P/E ratio is one of many ratios used in 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 SLC
Price per share = A$2.26
Earnings per share = A$0.012
∴ Price-Earnings Ratio = A$2.26 ÷ A$0.012 = 191x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 SLC, 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.
Since SLC’s P/E of 191x is higher than its industry peers (21x), it means that investors are paying more than they should for each dollar of SLC’s earnings. Therefore, according to this analysis, SLC is an over-priced stock.
A few caveats
Before you jump to the conclusion that SLC 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 SLC. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing riskier firms with SLC, then SLC’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 SLC. In this case, SLC’s P/E would be higher since investors would also reward SLC’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing SLC to are fairly valued by the market. If this does not hold, there is a possibility that SLC’s P/E is higher because firms in our peer group are being undervalued by the market.
What this means for you:
Since you may have already conducted your due diligence on SLC, 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for SLC’s future growth? Take a look at our free research report of analyst consensus for SLC’s outlook.
- Financial Health: Is SLC’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.