The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Versum Materials Inc (NYSE:VSM) is trading with a trailing P/E of 23.6x, which is higher than the industry average of 22.5x. 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. 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
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 VSM
Price per share = $38.55
Earnings per share = $1.631
∴ Price-Earnings Ratio = $38.55 ÷ $1.631 = 23.6x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as VSM, such as size and country of operation. 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.
At 23.6x, VSM’s P/E is higher than its industry peers (22.5x). This implies that investors are overvaluing each dollar of VSM’s earnings. This multiple is a median of profitable companies of 25 Semiconductor companies in US including Inside Secure, ARISE Technologies and SES Solar. As such, our analysis shows that VSM represents an over-priced stock.
A few caveats
Before you jump to the conclusion that VSM 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 VSM. 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 VSM, then investors would naturally value VSM at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with VSM, investors would also value VSM at a higher price since it is a higher growth investment. Both scenarios would explain why VSM has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing VSM to are fairly valued by the market. If this assumption does not hold true, VSM’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in VSM. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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 VSM’s future growth? Take a look at our free research report of analyst consensus for VSM’s outlook.
- Financial Health: Is VSM’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.
- 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.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.