Sunvest Corporation Limited (ASX:SVS) is currently trading at a trailing P/E of 38.2x, which is higher than the industry average of 20x. While SVS 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. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. Check out our latest analysis for Sunvest

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 SVS

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

SVS Price-Earnings Ratio = A$0.29 ÷ A$0.008 = 38.2x

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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to SVS, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since SVS’s P/E of 38.2x is higher than its industry peers (20x), it means that investors are paying more than they should for each dollar of SVS’s earnings. Therefore, according to this analysis, SVS is an over-priced stock.

A few caveats

While our conclusion might prompt you to sell your SVS shares immediately, there are two important assumptions you should be aware of. Firstly, our peer group contains companies that are similar to SVS. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with SVS, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing SVS to are fairly valued by the market. If this does not hold true, SVS’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.