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Software Aktiengesellschaft (XTRA:SOW) is currently trading at a trailing P/E of 22.2x, which is lower than the industry average of 35.6x. While SOW might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 Software
What you need to know about 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 SOW
Price-Earnings Ratio = Price per share ÷ Earnings per share
SOW Price-Earnings Ratio = €42.76 ÷ €1.928 = 22.2x
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. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as SOW, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since SOW’s P/E of 22.2x is lower than its industry peers (35.6x), it means that investors are paying less than they should for each dollar of SOW’s earnings. Therefore, according to this analysis, SOW is an under-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to buy SOW immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to SOW. 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 SOW, 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 SOW to are fairly valued by the market. If this is violated, SOW’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
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 SOW 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. 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 highly recommend you to complete your research by taking a look at the following: