Ricardo plc (LSE:RCDO) is currently trading at a trailing P/E of 20.9x, which is higher than the industry average of 18.9x. 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 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 Ricardo
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 RCDO
Price per share = £9.54
Earnings per share = £0.456
∴ Price-Earnings Ratio = £9.54 ÷ £0.456 = 20.9x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with 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 RCDO, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.
At 20.9x, RCDO’s P/E is higher than its industry peers (18.9x). This implies that investors are overvaluing each dollar of RCDO’s earnings. Therefore, according to this analysis, RCDO is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that RCDO 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 RCDO. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared riskier firms with RCDO, then investors would naturally value RCDO at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with RCDO, investors would also value RCDO at a higher price since it is a higher growth investment. Both scenarios would explain why RCDO has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing RCDO to are fairly valued by the market. If this assumption does not hold true, RCDO’s higher P/E ratio may be 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 RCDO, 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for RCDO’s future growth? Take a look at our free research report of analyst consensus for RCDO’s outlook.
- Past Track Record: Has RCDO 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 RCDO’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.