Should You Be Tempted To Buy SDL plc (LON:SDL) At Its Current PE Ratio?

I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.

SDL plc (LON:SDL) is currently trading at a trailing P/E of 25.9x, which is lower than the industry average of 35.5x. While this makes SDL appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.

Check out our latest analysis for SDL

Breaking down the Price-Earnings ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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.

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 SDL, 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.

SDL’s P/E of 25.9x is lower than its industry peers (35.5x), which implies that each dollar of SDL’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Software companies in GB including Team17 Group, Petards Group and Micro Focus International. Therefore, according to this analysis, SDL is an under-priced stock.

A few caveats

Before you jump to the conclusion that SDL represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to SDL. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with SDL, then investors would naturally value SDL at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with SDL, investors would also value SDL at a lower price since it is a lower growth investment. Both scenarios would explain why SDL has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing SDL to are fairly valued by the market. If this assumption is violated, SDL's P/E may be lower than its peers because its peers are actually overvalued 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 add more of SDL to your portfolio. 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:

1. Future Outlook: What are well-informed industry analysts predicting for SDL’s future growth? Take a look at our free research report of analyst consensus for SDL’s outlook.
2. Past Track Record: Has SDL 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 SDL's historicals for more clarity.
3. 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.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.