SATS Ltd (SGX:S58) trades with a trailing P/E of 22x, which is higher than the industry average of 19.5x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for SATS

Breaking down the Price-Earnings 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 S58

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

S58 Price-Earnings Ratio = SGD5.2 ÷ SGD0.236 = 22x

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 S58, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 22x, S58’s P/E is higher than its industry peers (19.5x). This implies that investors are overvaluing each dollar of S58’s earnings. Therefore, according to this analysis, S58 is an over-priced stock.

Assumptions to watch out for

While our conclusion might prompt you to sell your S58 shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to S58. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with S58, 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 S58 to are fairly valued by the market. If this does not hold, there is a possibility that S58’s P/E is lower because our peer group is overvalued by the market.

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.