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SDI Limited (ASX:SDI) trades with a trailing P/E of 14.8x, which is lower than the industry average of 26.9x. While this makes SDI appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, 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 SDI
What you need to know about the P/E ratio
P/E is a popular ratio used for relative valuation. 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 SDI
Price-Earnings Ratio = Price per share ÷ Earnings per share
SDI Price-Earnings Ratio = A$0.59 ÷ A$0.04 = 14.8x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SDI, 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 SDI’s P/E of 14.8x is lower than its industry peers (26.9x), it means that investors are paying less than they should for each dollar of SDI’s earnings. Therefore, according to this analysis, SDI is an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy SDI, 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 SDI, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with SDI, 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 SDI to are fairly valued by the market. If this does not hold true, SDI’s lower P/E ratio may be because firms in our peer group are 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.