Sociedad Química y Minera de Chile SA (NYSE:SQM) trades with a trailing P/E of 35.9x, which is higher than the industry average of 21.2x. While this makes SQM appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. Check out our latest analysis for Sociedad Química y Minera de Chile S.A
Demystifying the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 SQM
Price per share = $54.41
Earnings per share = $1.517
∴ Price-Earnings Ratio = $54.41 ÷ $1.517 = 35.9x
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 SQM, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use below. 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.
SQM’s P/E of 35.9x is higher than its industry peers (21.2x), which implies that each dollar of SQM’s earnings is being overvalued by investors. Therefore, according to this analysis, SQM is an over-priced stock.
A few caveats
Before you jump to the conclusion that SQM should be banished from your portfolio, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to SQM. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared lower growth firms with SQM, then SQM’s P/E would naturally be higher since investors would reward SQM’s higher growth with a higher price. Alternatively, if you inadvertently compared riskier firms with SQM, SQM’s P/E would again be higher since investors would reward SQM’s lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing SQM to are fairly valued by the market. If this does not hold, there is a possibility that SQM’s P/E is higher because firms in our peer group are being undervalued by the market.
What this means for you:
Are you a shareholder? 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 SQM. 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.
Are you a potential investor? If you are considering investing in SQM, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Sociedad Química y Minera de Chile S.A for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.