Softcat plc (LSE:SCT) is trading with a trailing P/E of 31.9x, which is higher than the industry average of 25.6x. 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. 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 Softcat
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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 SCT
Price per share = £6.92
Earnings per share = £0.217
∴ Price-Earnings Ratio = £6.92 ÷ £0.217 = 31.9x
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 SCT, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will 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.
Since SCT’s P/E of 31.9x is higher than its industry peers (25.6x), it means that investors are paying more than they should for each dollar of SCT’s earnings. Therefore, according to this analysis, SCT is an over-priced stock.
A few caveats
Before you jump to the conclusion that SCT should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to SCT. 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 SCT, then SCT’s P/E would naturally be higher since investors would reward SCT’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with SCT, SCT’s P/E would again be higher since investors would reward SCT’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing SCT to are fairly valued by the market. If this assumption does not hold true, SCT’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to SCT. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision. 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 SCT’s future growth? Take a look at our free research report of analyst consensus for SCT’s outlook.
- Past Track Record: Has SCT 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 SCT’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.