This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
The 600 Group PLC (LON:SIXH) trades with a trailing P/E of 8.5x, which is lower than the industry average of 22x. 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 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 600 Group
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. 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.
P/E Calculation for SIXH
Price-Earnings Ratio = Price per share ÷ Earnings per share
SIXH Price-Earnings Ratio = $0.24 ÷ $0.0280 = 8.5x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SIXH, 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. SIXH’s P/E of 8.5 is lower than its industry peers (22), which implies that each dollar of SIXH’s earnings is being undervalued by investors. This multiple is a median of profitable companies of 20 Machinery companies in GB including Tex Holdings, MayAir Group and Somero Enterprises. You can think of it like this: the market is suggesting that SIXH is a weaker business than the average comparable company.
A few caveats
However, 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 SIXH, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with SIXH, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing SIXH to are fairly valued by the market. If this does not hold, there is a possibility that SIXH’s P/E is lower because our peer group is overvalued 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 add more of SIXH to your portfolio. 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 urge you to complete your research by taking a look at the following: