Electronics for Imaging Inc (NASDAQ:EFII) trades with a trailing P/E of 45.3x, which is higher than the industry average of 18.9x. While EFII 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 Electronics for Imaging
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 EFII
Price per share = $30.73
Earnings per share = $0.678
∴ Price-Earnings Ratio = $30.73 ÷ $0.678 = 45.3x
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 EFII, such as capital structure and profitability. 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.
EFII’s P/E of 45.3x is higher than its industry peers (18.9x), which implies that each dollar of EFII’s earnings is being overvalued by investors. Therefore, according to this analysis, EFII is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your EFII shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to EFII. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing riskier firms with EFII, then EFII’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with EFII. In this case, EFII’s P/E would be higher since investors would also reward EFII’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing EFII to are fairly valued by the market. If this assumption does not hold true, EFII’s higher P/E ratio may be 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 EFII. 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:
1. Future Outlook: What are well-informed industry analysts predicting for EFII’s future growth? Take a look at our free research report of analyst consensus for EFII’s outlook.
2. Past Track Record: Has EFII 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 EFII’s historicals for more clarity.
3. 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.