Finzsoft Solutions Limited (NZSE:FIN) is trading with a trailing P/E of 136.9x, which is higher than the industry average of 31.4x. 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. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for Finzsoft Solutions
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 dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for FIN
Price per share = NZ$2.5
Earnings per share = NZ$0.018
∴ Price-Earnings Ratio = NZ$2.5 ÷ NZ$0.018 = 136.9x
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. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to FIN, 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.
Since FIN’s P/E of 136.9x is higher than its industry peers (31.4x), it means that investors are paying more than they should for each dollar of FIN’s earnings. As such, our analysis shows that FIN represents an over-priced stock.
A few caveats
Before you jump to the conclusion that FIN 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 FIN. 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 FIN, then FIN’s P/E would naturally be higher since investors would reward FIN’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with FIN, FIN’s P/E would again be higher since investors would reward FIN’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing FIN to are fairly valued by the market. If this assumption is violated, FIN’s P/E may be higher than its peers because its peers are actually undervalued by investors.
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 FIN. 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 FIN’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 FIN 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 FIN’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.