Smiths City Group Limited (NZSE:SCY) is trading with a trailing P/E of 11.6x, which is lower than the industry average of 12.4x. While SCY might seem like an attractive stock to buy, 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. View our latest analysis for Smiths City Group
What you need to know about the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 SCY
Price per share = NZ$0.53
Earnings per share = NZ$0.046
∴ Price-Earnings Ratio = NZ$0.53 ÷ NZ$0.046 = 11.6x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to SCY, such as company lifetime and products sold. 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 11.6x, SCY’s P/E is lower than its industry peers (12.4x). This implies that investors are undervaluing each dollar of SCY’s earnings. As such, our analysis shows that SCY represents an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy SCY immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to SCY. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared higher growth firms with SCY, then SCY’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with SCY, SCY’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing SCY to are fairly valued by the market. If this assumption is violated, SCY’s P/E may be lower than its peers because its peers are actually overvalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to SCY. 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:
- Financial Health: Is SCY’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has SCY 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 SCY’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.