Socket Mobile Inc (NASDAQ:SCKT) is currently trading at a trailing P/E of 1.9x, which is lower than the industry average of 18.8x. 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 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 SCKT
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 SCKT
Price-Earnings Ratio = Price per share ÷ Earnings per share
SCKT Price-Earnings Ratio = 3.66 ÷ 1.95 = 1.9x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to SCKT, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 1.9x, SCKT’s P/E is lower than its industry peers (18.8x). This implies that investors are undervaluing each dollar of SCKT’s earnings. Therefore, according to this analysis, SCKT is an under-priced stock.
A few caveats
While our conclusion might prompt you to buy SCKT immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to SCKT, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with SCKT, 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 SCKT to are fairly valued by the market. If this is violated, SCKT’s P/E may be lower than its peers as they are actually overvalued by investors.
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 SCKT 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 SCKT 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.