The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Synlait Milk Limited (NZSE:SML) trades with a trailing P/E of 28.6x, which is higher than the industry average of 15.6x. While SML 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.
Breaking down the Price-Earnings ratio
P/E is a popular ratio used for 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 dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for SML
Price per share = NZ$10.89
Earnings per share = NZ$0.381
∴ Price-Earnings Ratio = NZ$10.89 ÷ NZ$0.381 = 28.6x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful 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 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.
SML’s P/E of 28.6x is higher than its industry peers (15.6x), which implies that each dollar of SML’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 10 Food companies in NZ including Livestock Improvement, Allied Farmers and PGG Wrightson. Therefore, according to this analysis, SML is an over-priced stock.
A few caveats
However, before you rush out to sell your SML shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to SML. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with SML, then investors would naturally value SML at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with SML, investors would also value SML at a higher price since it is a higher growth investment. Both scenarios would explain why SML has a higher P/E ratio than its peers. 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:
Since you may have already conducted your due diligence on SML, 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 SML’s future growth? Take a look at our free research report of analyst consensus for SML’s outlook.
- 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.
- 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 firstname.lastname@example.org.