Spire Healthcare Group Plc (LSE:SPI) is currently trading at a trailing P/E of 52.5x, which is higher than the industry average of 46.6x. While SPI 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. Check out our latest analysis for Spire Healthcare Group
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief 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 SPI
Price per share = £2.2
Earnings per share = £0.042
∴ Price-Earnings Ratio = £2.2 ÷ £0.042 = 52.5x
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 SPI, 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.
SPI’s P/E of 52.5x is higher than its industry peers (46.6x), which implies that each dollar of SPI’s earnings is being overvalued by investors. Therefore, according to this analysis, SPI is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your SPI shares, 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 SPI. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing riskier firms with SPI, then SPI’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with SPI. In this case, SPI’s P/E would be higher since investors would also reward SPI’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing SPI to are fairly valued by the market. If this assumption is violated, SPI’s P/E may be higher than its peers because its peers are actually undervalued by investors.
What this means for you:
Since you may have already conducted your due diligence on SPI, 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 highly recommend 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.