In This Article:
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.
WPP plc (LON:WPP) trades with a trailing P/E of 5.8x, which is lower than the industry average of 20x. While this makes WPP appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
Check out our latest analysis for WPP
Demystifying the P/E ratio
P/E is a popular ratio used for relative valuation. 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.
P/E Calculation for WPP
Price-Earnings Ratio = Price per share ÷ Earnings per share
WPP Price-Earnings Ratio = £8.74 ÷ £1.51 = 5.8x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as WPP, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 5.8, WPP’s P/E is lower than its industry peers (20). This implies that investors are undervaluing each dollar of WPP’s earnings. This multiple is a median of profitable companies of 24 Media companies in GB including NAHL Group, SpaceandPeople and Catalyst Media Group. One could put it like this: the market is pricing WPP as if it is a weaker company than the average company in its industry.
Assumptions to watch out for
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to WPP. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with WPP, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing WPP to are fairly valued by the market. If this is violated, WPP’s P/E may be lower than its peers as they are actually overvalued by investors.
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 WPP. 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: