Duty Free International Limited (SGX:5SO) trades with a trailing P/E of 19x, which is higher than the industry average of 10.2x. While this makes 5SO 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. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for Duty Free International

Breaking down the Price-Earnings ratio

The P/E ratio is one of many ratios used in 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 5SO

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

5SO Price-Earnings Ratio = MYR0.79 ÷ MYR0.041 = 19x

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 5SO, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. Since 5SO’s P/E of 19x is higher than its industry peers (10.2x), it means that investors are paying more than they should for each dollar of 5SO’s earnings. Therefore, according to this analysis, 5SO is an over-priced stock.

A few caveats

Before you jump to the conclusion that 5SO 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 5SO, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with 5SO, 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 5SO to are fairly valued by the market. If this is violated, 5SO’s P/E may be lower than its peers as they are actually overvalued by investors.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.