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.
TPG Telecom Limited (ASX:TPM) is currently trading at a trailing P/E of 13.4x, which is lower than the industry average of 23x. Although some investors may jump to the conclusion that this is a great buying opportunity, understanding the assumptions behind the P/E ratio might change your mind. In this article, I will explain what the P/E ratio is as well as what you should look out for when using it.
Demystifying the P/E ratio
P/E is often used for relative valuation since earnings power is a chief 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for TPM
Price per share = A$5.79
Earnings per share = A$0.430
∴ Price-Earnings Ratio = A$5.79 ÷ A$0.430 = 13.4x
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 preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to TPM, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will 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.
Since TPM’s P/E of 13.4x is lower than its industry peers (23x), it means that investors are paying less than they should for each dollar of TPM’s earnings. This multiple is a median of profitable companies of 9 Telecom companies in AU including Telstra, TPC Consolidated and Spark New Zealand. Therefore, according to this analysis, TPM is an under-priced stock.
A few caveats
While our conclusion might prompt you to buy TPM immediately, there are two important assumptions you should be aware of. The first is that our “similar companies” are actually similar to TPM. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you accidentally compared higher growth firms with TPM, then TPM’s P/E would naturally be lower since investors would reward its peers’ higher growth with a higher price. Alternatively, if you inadvertently compared less risky firms with TPM, TPM’s P/E would again be lower since investors would reward its peers’ lower risk with a higher price as well. The second assumption that must hold true is that the stocks we are comparing TPM to are fairly valued by the market. If this assumption does not hold true, TPM’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on TPM, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined 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 urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for TPM’s future growth? Take a look at our free research report of analyst consensus for TPM’s outlook.
- Past Track Record: Has TPM 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 TPM’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.