Synthomer plc (LSE:SYNT) is currently trading at a trailing P/E of 15.8x, which is lower than the industry average of 21.6x. 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 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 Synthomer
Demystifying the P/E ratio
P/E is a popular ratio used for 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 pound of the company’s earnings.
P/E Calculation for SYNT
Price-Earnings Ratio = Price per share ÷ Earnings per share
SYNT Price-Earnings Ratio = £4.88 ÷ £0.31 = 15.8x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 SYNT, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 15.8x, SYNT’s P/E is lower than its industry peers (21.6x). This implies that investors are undervaluing each dollar of SYNT’s earnings. Therefore, according to this analysis, SYNT is an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy SYNT, 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 SYNT, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with SYNT, 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 SYNT to are fairly valued by the market. If this does not hold, there is a possibility that SYNT’s P/E is lower because our peer group is overvalued by the market.
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 add more of SYNT 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.
Are you a potential investor? If you are considering investing in SYNT, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.