Sandstorm Gold Ltd (TSX:SSL) is trading with a trailing P/E of 72.2x, which is higher than the industry average of 9.8x. While SSL 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Sandstorm Gold
What you need to know about the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 SSL
Price per share = $4.55
Earnings per share = $0.063
∴ Price-Earnings Ratio = $4.55 ÷ $0.063 = 72.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SSL, such as capital structure and profitability. 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 SSL’s P/E of 72.2x is higher than its industry peers (9.8x), it means that investors are paying more than they should for each dollar of SSL’s earnings. As such, our analysis shows that SSL represents an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that SSL 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 SSL. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you accidentally compared lower growth firms with SSL, then SSL’s P/E would naturally be higher since investors would reward SSL’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with SSL, SSL’s P/E would again be higher since investors would reward SSL’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing SSL to are fairly valued by the market. If this does not hold, there is a possibility that SSL’s P/E is higher 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 SSL. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for SSL’s future growth? Take a look at our free research report of analyst consensus for SSL’s outlook.
- Past Track Record: Has SSL 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 SSL’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.