Over the Wire Holdings Limited (ASX:OTW) trades with a trailing P/E of 24.2x, which is lower than the industry average of 42x. While this makes OTW 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. See our latest analysis for OTW
What you need to know about 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for OTW
Price per share = 2
Earnings per share = 0.083
∴ Price-Earnings Ratio = 2 ÷ 0.083 = 24.2x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to OTW, such as company lifetime and products sold. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
At 24.2x, OTW’s P/E is lower than its industry peers (42x). This implies that investors are undervaluing each dollar of OTW’s earnings. As such, our analysis shows that OTW represents an under-priced stock.
Assumptions to watch out for
However, before you rush out to buy OTW, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to OTW. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you are inadvertently comparing lower risk firms with OTW, then OTW’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with OTW. In this case, OTW’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing OTW to are fairly valued by the market. If this does not hold, there is a possibility that OTW’s P/E is lower because firms in our peer group are being overvalued by the market.
What this means for you:
Are you a shareholder? 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 OTW 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.
Are you a potential investor? If OTW 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 Over the Wire Holdings 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.