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Sonic Automotive Inc (NYSE:SAH) is trading with a trailing P/E of 9x, which is lower than the industry average of 18.2x. While SAH 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. See our latest analysis for Sonic Automotive
Demystifying the P/E 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 SAH
Price-Earnings Ratio = Price per share ÷ Earnings per share
SAH Price-Earnings Ratio = $19.25 ÷ $2.138 = 9x
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 SAH, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. SAH’s P/E of 9x is lower than its industry peers (18.2x), which implies that each dollar of SAH’s earnings is being undervalued by investors. As such, our analysis shows that SAH represents an under-priced stock.
A few caveats
However, before you rush out to buy SAH, 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 SAH, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with SAH, 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 SAH to are fairly valued by the market. If this is violated, SAH’s P/E may be lower than its peers as they are actually overvalued by investors.
What this means for you:
Since you may have already conducted your due diligence on SAH, the undervaluation of the stock may mean it is a good time to top up on 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: