Sandfire Resources NL (ASX:SFR) is trading with a trailing P/E of 12x, which is higher than the industry average of 11.1x. While this makes SFR 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 Sandfire Resources NL
Demystifying the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 SFR
Price-Earnings Ratio = Price per share ÷ Earnings per share
SFR Price-Earnings Ratio = 5.9 ÷ 0.492 = 12x
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 SFR, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. At 12x, SFR’s P/E is higher than its industry peers (11.1x). This implies that investors are overvaluing each dollar of SFR’s earnings. As such, our analysis shows that SFR represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your SFR shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to SFR. 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 SFR, 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 SFR to are fairly valued by the market. If this does not hold, there is a possibility that SFR’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on SFR, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.
Are you a potential investor? If you are considering investing in SFR, 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.