Skyworks Solutions Inc (NASDAQ:SWKS) is currently trading at a trailing P/E of 18.7x, which is lower than the industry average of 23.6x. While this makes SWKS appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Skyworks Solutions

Demystifying 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 SWKS

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

SWKS Price-Earnings Ratio = $102.29 ÷ $5.481 = 18.7x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. Our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to SWKS, such as company lifetime and products sold. A common peer group is companies that exist in the same industry, which is what I use. Since SWKS’s P/E of 18.7x is lower than its industry peers (23.6x), it means that investors are paying less than they should for each dollar of SWKS’s earnings. Therefore, according to this analysis, SWKS is an under-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to buy SWKS immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to SWKS, or else the difference in P/E might be a result of other factors. For example, if you are comparing lower risk firms with SWKS, 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 SWKS to are fairly valued by the market. If this does not hold, there is a possibility that SWKS’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 undervaluation could signal a good buying opportunity to increase your exposure to SWKS. 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.

Are you a potential investor? If SWKS has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.

PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Skyworks Solutions for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn’t properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.

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.