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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 start learning about core concepts of fundamental analysis on practical examples from today’s market.
Southern Cross Electrical Engineering Limited (ASX:SXE) is currently trading at a trailing P/E of 17, which is higher than the industry average of 15.2. While this might not seem positive, 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 Southern Cross Electrical Engineering
Breaking down the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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.
P/E Calculation for SXE
Price-Earnings Ratio = Price per share ÷ Earnings per share
SXE Price-Earnings Ratio = A$0.69 ÷ A$0.0405 = 17x
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 SXE, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. SXE’s P/E of 17 is higher than its industry peers (15.2), which implies that each dollar of SXE’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 11 Construction companies in AU including JC International Group, Primero Group and Lycopodium. You could also say that the market is suggesting that SXE is a stronger business than the average comparable company.
A few caveats
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. Firstly, that our peer group contains companies that are similar to SXE. If this isn’t the case, the difference in P/E could be due to other factors. Take, for example, the scenario where Southern Cross Electrical Engineering Limited is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. Of course, it is possible that the stocks we are comparing with SXE are not fairly valued. So while we can reasonably surmise that it is optimistically valued relative to a peer group, it might be fairly valued, if the peer group is undervalued.