Switch Inc (NYSE:SWCH) is currently trading at a trailing P/E of 107.9x, which is higher than the industry average of 29.4x. 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. View our latest analysis for Switch

Demystifying the P/E ratio

P/E is often used for relative valuation since earnings power is a chief driver of investment value. 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 SWCH

Price-Earnings Ratio = Price per share ÷ Earnings per share

SWCH Price-Earnings Ratio = 17 ÷ 0.158 = 107.9x

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 SWCH, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 107.9x, SWCH’s P/E is higher than its industry peers (29.4x). This implies that investors are overvaluing each dollar of SWCH’s earnings. As such, our analysis shows that SWCH represents an over-priced stock.

A few caveats

Before you jump to the conclusion that SWCH should be banished from your portfolio, it is important to realise that our conclusion rests on two assertions. The first is that our “similar companies” are actually similar to SWCH, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with SWCH, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing SWCH to are fairly valued by the market. If this does not hold true, SWCH’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

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 SWCH. 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.

Are you a potential investor? If SWCH has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.