In This Article:
This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about the link between company’s fundamentals and stock market performance.
SSE plc (LON:SSE) is trading with a trailing P/E of 13.9, which is higher than the industry average of 10.7. Though this might seem to be a negative, 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.
Check out our latest analysis for SSE
Breaking down the Price-Earnings ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 SSE
Price-Earnings Ratio = Price per share ÷ Earnings per share
SSE Price-Earnings Ratio = £11.29 ÷ £0.813 = 13.9x
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 SSE, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. At 13.9, SSE’s P/E is higher than its industry peers (10.7). This implies that investors are overvaluing each dollar of SSE’s earnings. Since the Electric Utilities sector in GB is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as OPG Power Ventures, Jersey Electricity and . You could think of it like this: the market is pricing SSE as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that there are assumptions in this analysis. The first is that our “similar companies” are actually similar to SSE. If not, the difference in P/E might be a result of other factors. Take, for example, the scenario where SSE plc is growing profits more quickly than the average comparable company. In that case, the market may be correct to value it on a higher P/E ratio. We should also be aware that the stocks we are comparing to SSE may not be fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.