Simulations Plus Inc (NASDAQ:SLP) is currently trading at a trailing P/E of 45.8x, which is higher than the industry average of 34.6x. 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. 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 Simulations Plus

Demystifying the P/E 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 SLP

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

SLP Price-Earnings Ratio = $16.3 ÷ $0.356 = 45.8x

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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as SLP, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 45.8x, SLP’s P/E is higher than its industry peers (34.6x). This implies that investors are overvaluing each dollar of SLP’s earnings. As such, our analysis shows that SLP represents an over-priced stock.

Assumptions to watch out for

However, before you rush out to sell your SLP 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 SLP, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with SLP, 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 SLP to are fairly valued by the market. If this does not hold, there is a possibility that SLP’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 SLP, 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 SLP, looking at the PE ratio on its own is not enough to make a well-informed decision. You will benefit from looking at additional analysis and considering its intrinsic valuation along with other relative valuation metrics like PEG and EV/Sales.