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Signet Jewelers Limited (NYSE:SIG) is currently trading at a trailing P/E of 5x, which is lower than the industry average of 19.2x. While this makes SIG 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. See our latest analysis for Signet Jewelers
Breaking down the Price-Earnings 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 SIG
Price-Earnings Ratio = Price per share ÷ Earnings per share
SIG Price-Earnings Ratio = $38.84 ÷ $7.721 = 5x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to SIG, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since SIG’s P/E of 5x is lower than its industry peers (19.2x), it means that investors are paying less than they should for each dollar of SIG’s earnings. As such, our analysis shows that SIG represents an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that SIG 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 SIG. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with SIG, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing SIG to are fairly valued by the market. If this is violated, SIG’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current undervaluation could signal a good buying opportunity to increase your exposure to SIG. 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. 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 highly recommend you to complete your research by taking a look at the following: