Simonds Group Limited (ASX:SIO) is currently trading at a trailing P/E of 20.4x, which is higher than the industry average of 16.5x. While this makes SIO 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 explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Simonds Group
Breaking down the Price-Earnings 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 SIO
Price-Earnings Ratio = Price per share ÷ Earnings per share
SIO Price-Earnings Ratio = A$0.3 ÷ A$0.014 = 20.4x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as SIO, 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 20.4x, SIO’s P/E is higher than its industry peers (16.5x). This implies that investors are overvaluing each dollar of SIO’s earnings. As such, our analysis shows that SIO represents an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your SIO shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to SIO. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with SIO, 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 SIO to are fairly valued by the market. If this is violated, SIO’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? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in SIO. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.