Sonic Healthcare Limited (ASX:SHL) is currently trading at a trailing P/E of 20.5x, which is higher than the industry average of 16.6x. While SHL might seem like a stock to avoid or sell if you own it, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. 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 SHL
What you need to know about 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 SHL
Price-Earnings Ratio = Price per share ÷ Earnings per share
SHL Price-Earnings Ratio = 21.01 ÷ 1.027 = 20.5x
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 SHL, 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 20.5x, SHL’s P/E is higher than its industry peers (16.6x). This implies that investors are overvaluing each dollar of SHL’s earnings. Therefore, according to this analysis, SHL is an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your SHL shares, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to SHL, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with SHL, 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 SHL to are fairly valued by the market. If this does not hold true, SHL’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? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in SHL. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.