Wisetech Global Limited (ASX:WTC) trades with a trailing P/E of 128.7x, which is higher than the industry average of 33.1x. While this makes WTC 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. See our latest analysis for Wisetech Global
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 dollar of the company’s earnings.
P/E Calculation for WTC
Price-Earnings Ratio = Price per share ÷ Earnings per share
WTC Price-Earnings Ratio = A$14 ÷ A$0.109 = 128.7x
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 WTC, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 128.7x, WTC’s P/E is higher than its industry peers (33.1x). This implies that investors are overvaluing each dollar of WTC’s earnings. Therefore, according to this analysis, WTC is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that WTC should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to WTC. 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 WTC, 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 WTC to are fairly valued by the market. If this is violated, WTC’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? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to WTC. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.