I am writing today to help inform people who are new to the stock market and want to learn about the link between company’s fundamentals and stock market performance.
Sandvik AB (STO:SAND) is trading with a trailing P/E of 13.8x, which is lower than the industry average of 20x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for SAND
Price per share = SEK153.8
Earnings per share = SEK11.105
∴ Price-Earnings Ratio = SEK153.8 ÷ SEK11.105 = 13.8x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SAND, such as capital structure and profitability. 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.
SAND’s P/E of 13.8x is lower than its industry peers (20x), which implies that each dollar of SAND’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 24 Machinery companies in SE including AB SKF, AB SKF and AB Volvo. Therefore, according to this analysis, SAND is an under-priced stock.
Assumptions to be aware of
However, before you rush out to buy SAND, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to SAND. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with SAND, then investors would naturally value SAND at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with SAND, investors would also value SAND at a lower price since it is a lower growth investment. Both scenarios would explain why SAND has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing SAND to are fairly valued by the market. If this assumption does not hold true, SAND’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on SAND, the undervaluation of the stock may mean it is a good time to top up on 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 SAND’s future growth? Take a look at our free research report of analyst consensus for SAND’s outlook.
- Past Track Record: Has SAND 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 SAND’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.