Actually, if I remember correctly it's a bit more complicated than that:
- Initially, "sie" means both "she" and "they"
- But when it appears capitalised, "Sie" is a formal "you" (like Spanish "usted")
- When using it as "she", the verb is in third person singular, "sie isst"
- When using it as formal "you" and as "they", the verb is in third person plural, "sie essen" and "Sie essen"
- In this example, "Sie" is the first word in the sentence. Therefore we can't use the capitalisation to see if it means formal "you" or "they". In this case, only the context can help us
- Since there is no context in this sentence, both "you are eating" (formal) and "they are eating" are valid answers here
Please correct me if I am wrong!
So to summarize:
they eat / sie essen,
she eats / sie isst,
you eat/ Sie essen (formal),
you eat / du isst (informal),
you all eat / ihr esst.
In a nutshell: "sie" can have 3 meanings: 1. they, 2. she, 3. "formal" you. While the English "you" can also be translated to 3 different words in German: 1. du (2nd person singular, informal) ex. "Hey, you!" 2. Sie (2nd person singular, formal) ex. "Your majesty~" 3. ihr (2nd person plural) ex. "See y'all later!"
No: capitalised "Sie" is a formal "you", if I remember correctly. In this example, it is not possible to know if it is formal "you" or "they", because "Sie" is the first word in the sentence, and regardless of other considerations. It's ambiguous and both answers are correct.
English has a similar ambiguity: it's not possible to know if "you are eating" refers to a singular or a plural subject. Translating into German, both "Du isst" and "Ihr esst" would be correct. Also would be correct "Sie essen", as Modern English doesn't have the distinction between formal/informal. Precursors of the modern English language had the informal "thou", that is mostly lost nowadays.