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Does Renishaw plc’s (LON:RSW) PE Ratio Warrant A Sell?

Renishaw plc (LON:RSW) is currently trading at a trailing P/E of 29.5x, which is higher than the industry average of 18.8x. While this makes RSW appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.

Breaking down the P/E ratio

The P/E ratio is a popular ratio used in relative valuation since earnings power is a key driver of investment value. 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 RSW

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

RSW Price-Earnings Ratio = £55.65 ÷ £1.889 = 29.5x

The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as RSW, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. At 29.5x, RSW’s P/E is higher than its industry peers (18.8x). This implies that investors are overvaluing each dollar of RSW’s earnings. As such, our analysis shows that RSW represents an over-priced stock.

A few caveats

However, before you rush out to sell your RSW 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 RSW. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with RSW, 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 RSW to are fairly valued by the market. If this does not hold true, RSW’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 rebalance your portfolio and reduce your holdings in RSW. 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:

1. Future Outlook: What are well-informed industry analysts predicting for RSW’s future growth? Take a look at our free research report of analyst consensus for RSW’s outlook.
2. Past Track Record: Has RSW 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 RSW’s historicals for more clarity.
3. 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 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.