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Should You Be Tempted To Buy TPG Telecom Limited (ASX:TPM) Because Of Its PE Ratio?

TPG Telecom Limited (ASX:TPM) is trading with a trailing P/E of 12.2x, which is lower than the industry average of 20.7x. While this makes TPM appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, 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 TPG Telecom

Breaking down the Price-Earnings ratio

A common ratio used for relative valuation is the P/E ratio. 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.

Formula

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

P/E Calculation for TPM

Price per share = A\$5.25

Earnings per share = A\$0.43

∴ Price-Earnings Ratio = A\$5.25 ÷ A\$0.43 = 12.2x

The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against 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 it is expected that similar companies have similar P/E ratios, we can come to some conclusions about the stock if the ratios are different.

TPM’s P/E of 12.2x is lower than its industry peers (20.7x), which implies that each dollar of TPM’s earnings is being undervalued by investors. Therefore, according to this analysis, TPM is an under-priced stock.

Assumptions to be aware of

Before you jump to the conclusion that TPM represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our peer group actually contains companies that are similar to TPM. If this isn’t the case, the difference in P/E could be due to some 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 is violated, TPM’s P/E may be lower than its peers because its peers are actually overvalued by investors.

What this means for you:

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 TPM. 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. 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 TPM’s future growth? Take a look at our free research report of analyst consensus for TPM’s outlook.
2. 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.
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.