Paychex Inc (NASDAQ:PAYX) is trading with a trailing P/E of 26.4x, which is lower than the industry average of 28.5x. While this makes PAYX appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Paychex
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 PAYX
Price-Earnings Ratio = Price per share ÷ Earnings per share
PAYX Price-Earnings Ratio = 59.96 ÷ 2.272 = 26.4x
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 PAYX, 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 26.4x, PAYX’s P/E is lower than its industry peers (28.5x). This implies that investors are undervaluing each dollar of PAYX’s earnings. Therefore, according to this analysis, PAYX is an under-priced stock.
A few caveats
Before you jump to the conclusion that PAYX is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to PAYX. 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 PAYX, 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 PAYX to are fairly valued by the market. If this does not hold, there is a possibility that PAYX’s P/E is lower because our peer group is overpriced by the market.
What this means for you:
Are you a shareholder? 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 PAYX 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.
Are you a potential investor? If you are considering investing in PAYX, basing your decision on the PE metric at one point in time is certainly not sufficient. I recommend you do additional analysis by looking at its intrinsic valuation and using other relative valuation ratios like PEG or EV/EBITDA.