Advanced Medical Solutions Group plc (AIM:AMS) trades with a trailing P/E of 39.7x, which is higher than the industry average of 31.3x. While AMS 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Advanced Medical Solutions Group
Breaking down the Price-Earnings 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 pound of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for AMS
Price per share = £3.29
Earnings per share = £0.083
∴ Price-Earnings Ratio = £3.29 ÷ £0.083 = 39.7x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as AMS, 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 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 39.7x, AMS’s P/E is higher than its industry peers (31.3x). This implies that investors are overvaluing each dollar of AMS’s earnings. As such, our analysis shows that AMS represents an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your AMS shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to AMS. 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 AMS, then AMS’s P/E would naturally be higher since investors would reward AMS’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with AMS, AMS’s P/E would again be higher since investors would reward AMS’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing AMS to are fairly valued by the market. If this assumption is violated, AMS’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 AMS. 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for AMS’s future growth? Take a look at our free research report of analyst consensus for AMS’s outlook.
- Past Track Record: Has AMS 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 AMS’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.