This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Enghouse Systems Limited (TSE:ENGH) trades with a trailing P/E of 41.7x, which is lower than the industry average of 61.1x. While this makes ENGH appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
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 ENGH
Price-Earnings Ratio = Price per share ÷ Earnings per share
ENGH Price-Earnings Ratio = CA$80.71 ÷ CA$1.934 = 41.7x
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 ENGH, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use. Since ENGH’s P/E of 41.7 is lower than its industry peers (61.1), it means that investors are paying less for each dollar of ENGH’s earnings. This multiple is a median of profitable companies of 9 Software companies in CA including NamSys, Intrinsyc Technologies and Tecsys. You can think of it like this: the market is suggesting that ENGH is a weaker business than the average comparable company.
Assumptions to watch out for
Before you jump to conclusions it is important to realise that our assumptions rests on two assertions. The first is that our “similar companies” are actually similar to ENGH, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with ENGH, 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 ENGH to are fairly valued by the market. If this does not hold true, ENGH’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of ENGH to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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:
- Future Outlook: What are well-informed industry analysts predicting for ENGH’s future growth? Take a look at our free research report of analyst consensus for ENGH’s outlook.
- Past Track Record: Has ENGH been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of ENGH’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past 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. For errors that warrant correction please contact the editor at email@example.com.