In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Smith & Nephew plc (LON:SN.) is trading with a trailing P/E of 20.1x, which is lower than the industry average of 29.5x. Although some investors may jump to the conclusion that this is a great buying opportunity, 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.
Check out our latest analysis for Smith & Nephew
Breaking down the Price-Earnings ratio
A common ratio used for relative valuation is the P/E ratio. 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 SN.
Price-Earnings Ratio = Price per share ÷ Earnings per share
SN. Price-Earnings Ratio = $16.54 ÷ $0.822 = 20.1x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SN., 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 20.1, SN.’s P/E is lower than its industry peers (29.5). This implies that investors are undervaluing each dollar of SN.’s earnings. This multiple is a median of profitable companies of 10 Medical Equipment companies in GB including Convatec Group, Inspiration Healthcare Group and Scientific Digital Imaging. One could put it like this: the market is pricing SN. as if it is a weaker company than the average company in its industry.
A few caveats
However, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to SN.. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with SN., 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 SN. to are fairly valued by the market. If this does not hold true, SN.’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
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 SN.. 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 urge you to complete your research by taking a look at the following: