Sprouts Farmers Market Inc (NASDAQ:SFM) is trading with a trailing P/E of 24.4x, which is higher than the industry average of 20.1x. While this makes SFM appear like a stock to avoid or sell if you own it, 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. View our latest analysis for Sprouts Farmers Market
Demystifying the P/E ratio
The P/E ratio is one of many ratios used in 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 SFM
Price-Earnings Ratio = Price per share ÷ Earnings per share
SFM Price-Earnings Ratio = $24.12 ÷ $0.988 = 24.4x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to SFM, such as company lifetime and products sold. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. SFM’s P/E of 24.4x is higher than its industry peers (20.1x), which implies that each dollar of SFM’s earnings is being overvalued by investors. As such, our analysis shows that SFM represents an over-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that SFM should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to SFM, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with SFM, 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 SFM to are fairly valued by the market. If this is violated, SFM’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on SFM, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above.
Are you a potential investor? If you are considering investing in SFM, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.