In This Article:
This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Service Stream Limited (ASX:SSM) trades on a trailing P/E of 15.7. This isn’t too far from the industry average (which is 16). While SSM might seem like an attractive stock to buy, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
View our latest analysis for Service Stream
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief 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 SSM
Price-Earnings Ratio = Price per share ÷ Earnings per share
SSM Price-Earnings Ratio = A$1.78 ÷ A$0.113 = 15.7x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SSM, 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. Service Stream Limited (ASX:SSM) trades on a trailing P/E of 15.7. This isn’t too far from the industry average (which is 16). This multiple is a median of profitable companies of 12 Construction companies in AU including JC International Group, Primero Group and Civmec. One could put it like this: the market is pricing SSM as if it is roughly average for its industry.
A few caveats
However, 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 SSM, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with SSM, 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 SSM to are fairly valued by the market. If this does not hold, there is a possibility that SSM’s P/E is lower because our peer group is overvalued by the market.