United Engineers Limited (SGX:U04) trades with a trailing P/E of 28.5x, which is higher than the industry average of 10.4x. While U04 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 break down what the P/E ratio is, how to interpret it and what to watch out for. See our latest analysis for United Engineers
Breaking down the P/E ratio
A common ratio used for relative valuation is the P/E ratio. 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 U04
Price-Earnings Ratio = Price per share ÷ Earnings per share
U04 Price-Earnings Ratio = SGD2.65 ÷ SGD0.093 = 28.5x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as U04, 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 28.5x, U04’s P/E is higher than its industry peers (10.4x). This implies that investors are overvaluing each dollar of U04’s earnings. Therefore, according to this analysis, U04 is an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your U04 shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to U04. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared higher growth firms with U04, 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 U04 to are fairly valued by the market. If this does not hold, there is a possibility that U04’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to U04. Now that you understand the ins and outs of the PE metric, you should know to bear in mind its limitations before you make an investment decision.