Does Synlait Milk Limited's (NZE:SML) PE Ratio Warrant A Sell?

Synlait Milk Limited (NZSE:SML) trades with a trailing P/E of 28.2x, which is higher than the industry average of 19.5x. While this makes SML 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. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Synlait Milk

Demystifying the P/E ratio

The P/E ratio is one of many ratios used in relative valuation. 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.

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 SML, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.

At 28.2x, SML’s P/E is higher than its industry peers (19.5x). This implies that investors are overvaluing each dollar of SML’s earnings. As such, our analysis shows that SML represents an over-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to sell your SML shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to SML. 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 SML, then SML’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 SML. In this case, SML’s P/E would be higher since investors would also reward SML’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing SML to are fairly valued by the market. If this assumption does not hold true, SML’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 SML. 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:

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

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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.