This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Rosenblatt Group Plc (LON:RBGP) is currently trading at a trailing P/E of 17.9x, which is higher than the industry average of 17.8x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
Breaking down 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 pound of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for RBGP
Price per share = £1.08
Earnings per share = £0.0600
∴ Price-Earnings Ratio = £1.08 ÷ £0.0600 = 17.9x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as RBGP, such as size and country of operation. 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 17.9x, RBGP’s P/E is higher than its industry peers (17.8x). This implies that investors are overvaluing each dollar of RBGP’s earnings. This multiple is a median of profitable companies of 24 Professional Services companies in GB including Tekcapital, Servoca and Kellan Group. Therefore, according to this analysis, RBGP is an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your RBGP shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to RBGP. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared lower growth firms with RBGP, then RBGP’s P/E would naturally be higher since investors would reward RBGP’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with RBGP, RBGP’s P/E would again be higher since investors would reward RBGP’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing RBGP to are fairly valued by the market. If this assumption is violated, RBGP’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 RBGP. 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:
- Valuation: What is RBGP worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether RBGP is currently mispriced by the market.
- 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 firstname.lastname@example.org.