Spirit AeroSystems Holdings Inc (NYSE:SPR) trades with a trailing P/E of 28x, which is higher than the industry average of 24.2x. While this makes SPR 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. View our latest analysis for Spirit AeroSystems Holdings

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 SPR

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

SPR Price-Earnings Ratio = 78.59 ÷ 2.806 = 28x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful 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 SPR, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. Since SPR's P/E of 28x is higher than its industry peers (24.2x), it means that investors are paying more than they should for each dollar of SPR's earnings. As such, our analysis shows that SPR represents an over-priced stock.

Assumptions to watch out for

However, before you rush out to sell your SPR shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to SPR. 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 SPR, 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 SPR to are fairly valued by the market. If this does not hold true, SPR’s lower P/E ratio may be because firms in our peer group are overvalued by the market.

What this means for you:

Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to SPR. 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.

Are you a potential investor? If you are considering investing in SPR, 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.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Spirit AeroSystems Holdings for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

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.