SP Corporation Limited (SGX:AWE) trades with a trailing P/E of 32.5x, which is higher than the industry average of 22.6x. 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. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for SP
Breaking down the Price-Earnings ratio
The P/E ratio is one of many ratios used in 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 AWE
Price-Earnings Ratio = Price per share ÷ Earnings per share
AWE Price-Earnings Ratio = SGD0.82 ÷ SGD0.025 = 32.5x
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. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to AWE, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. AWE’s P/E of 32.5x is higher than its industry peers (22.6x), which implies that each dollar of AWE’s earnings is being overvalued by investors. Therefore, according to this analysis, AWE is an over-priced stock.
A few caveats
While our conclusion might prompt you to sell your AWE shares immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to AWE, or else the difference in P/E might be a result of other factors. For example, if you compared higher growth firms with AWE, 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 AWE to are fairly valued by the market. If this does not hold, there is a possibility that AWE’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on AWE, 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I highly recommend you to complete your research by taking a look at the following: