I am writing today to help inform people who are new to the stock market and want to begin learning the link between Spire Healthcare Group plc (LON:SPI)’s fundamentals and stock market performance.
Spire Healthcare Group plc (LON:SPI) trades with a trailing P/E of 58.9x, which is higher than the industry average of 55.2x. While this makes SPI appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View out our latest analysis for Spire Healthcare Group
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 dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for SPI
Price per share = £2.47
Earnings per share = £0.0419
∴ Price-Earnings Ratio = £2.47 ÷ £0.0419 = 58.9x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SPI, such as capital structure and profitability. 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.
Since SPI’s P/E of 58.9x is higher than its industry peers (55.2x), it means that investors are paying more than they should for each dollar of SPI’s earnings. Therefore, according to this analysis, SPI is an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your SPI shares immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to SPI. 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 SPI, then SPI’s P/E would naturally be higher since investors would reward SPI’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with SPI, SPI’s P/E would again be higher since investors would reward SPI’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing SPI to are fairly valued by the market. If this does not hold, there is a possibility that SPI’s P/E is higher because firms in our peer group are being undervalued 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 rebalance your portfolio and reduce your holdings in SPI. 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:
- Future Outlook: What are well-informed industry analysts predicting for SPI’s future growth? Take a look at our free research report of analyst consensus for SPI’s outlook.
- Past Track Record: Has SPI 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 SPI’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.