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ams AG (SWX:AMS) is currently trading at a trailing P/E of 36.9x, which is higher than the industry average of 31x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for ams
Breaking down the P/E 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 AMS
Price-Earnings Ratio = Price per share ÷ Earnings per share
AMS Price-Earnings Ratio = €75.57 ÷ €2.049 = 36.9x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to AMS, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 36.9x, AMS’s P/E is higher than its industry peers (31x). This implies that investors are overvaluing each dollar of AMS’s earnings. Therefore, according to this analysis, AMS is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your AMS shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to AMS. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with AMS, then its P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing AMS to are fairly valued by the market. If this is violated, AMS’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 rebalance your portfolio and reduce your holdings in AMS. 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 urge you to complete your research by taking a look at the following: