This analysis is intended to introduce important early concepts to people who are starting to invest and want to begin learning the link between Sonic Automotive Inc (NYSE:SAH)’s fundamentals and stock market performance.
Sonic Automotive Inc (NYSE:SAH) trades with a trailing P/E of 10.4x, which is lower than the industry average of 20.1x. While SAH 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. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. Check out our latest analysis for Sonic Automotive
Breaking down 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 SAH
Price per share = $22
Earnings per share = $2.117
∴ Price-Earnings Ratio = $22 ÷ $2.117 = 10.4x
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 SAH, 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 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.
Since SAH’s P/E of 10.4x is lower than its industry peers (20.1x), it means that investors are paying less than they should for each dollar of SAH’s earnings. As such, our analysis shows that SAH represents an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that SAH represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to SAH. 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 SAH, then investors would naturally value SAH at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with SAH, investors would also value SAH at a lower price since it is a lower growth investment. Both scenarios would explain why SAH has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing SAH to are fairly valued by the market. If this does not hold, there is a possibility that SAH’s P/E is lower because firms in our peer group are being overvalued by the market.
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 SAH. 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:
- Future Outlook: What are well-informed industry analysts predicting for SAH’s future growth? Take a look at our free research report of analyst consensus for SAH’s outlook.
- Past Track Record: Has SAH 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 SAH’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.