Q-Soft Verwaltungs AG (BST:QS6A) is trading with a trailing P/E of 22.2x, which is lower than the industry average of 36.8x. Although some investors may jump to the conclusion that this is a great buying opportunity, 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. Check out our latest analysis for Q-Soft Verwaltungs
Demystifying 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. By comparing a stock’s price per share to its earnings per share, we are able to see 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 QS6A
Price per share = €3.5
Earnings per share = €0.158
∴ Price-Earnings Ratio = €3.5 ÷ €0.158 = 22.2x
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 QS6A, such as company lifetime and products sold. 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.
QS6A’s P/E of 22.2x is lower than its industry peers (36.8x), which implies that each dollar of QS6A’s earnings is being undervalued by investors. As such, our analysis shows that QS6A represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy QS6A, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to QS6A. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with QS6A, then investors would naturally value QS6A at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with QS6A, investors would also value QS6A at a lower price since it is a lower growth investment. Both scenarios would explain why QS6A has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing QS6A to are fairly valued by the market. If this does not hold, there is a possibility that QS6A’s P/E is lower because firms in our peer group are being overvalued 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 add more of QS6A to your portfolio. 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:
- Financial Health: Is QS6A’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.
- Past Track Record: Has QS6A 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 QS6A’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.