Rocca Spólka Akcyjna (WSE:RCA) is currently trading at a trailing P/E of 58.8x, which is higher than the industry average of 19.4x. While RCA 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Rocca Spólka Akcyjna
Breaking down the Price-Earnings ratio
The P/E ratio is one of many ratios used in 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 RCA
Price per share = PLN0.5
Earnings per share = PLN0.009
∴ Price-Earnings Ratio = PLN0.5 ÷ PLN0.009 = 58.8x
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 RCA, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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 RCA’s P/E of 58.8x is higher than its industry peers (19.4x), it means that investors are paying more than they should for each dollar of RCA’s earnings. Therefore, according to this analysis, RCA is an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that RCA 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 RCA. 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 RCA, then investors would naturally value RCA at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with RCA, investors would also value RCA at a higher price since it is a higher growth investment. Both scenarios would explain why RCA has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing RCA to are fairly valued by the market. If this does not hold, there is a possibility that RCA’s P/E is higher 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 RCA. 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 urge you to complete your research by taking a look at the following:
- Financial Health: Is RCA’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 RCA 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 RCA’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.