The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
The Toronto-Dominion Bank (TSE:TD) trades with a trailing P/E of 14, which is higher than the industry average of 12.9. While this might not seem positive, it is important to understand the assumptions behind the P/E ratio before you make any investment decisions. In this article, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio.
What you need to know about the P/E ratio
P/E is a popular ratio used for relative valuation. 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 TD
Price per share = CA$79.31
Earnings per share = CA$5.665
∴ Price-Earnings Ratio = CA$79.31 ÷ CA$5.665 = 14x
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 TD, such as capital structure and profitability. A common peer group is companies that exist in the same industry, which is what I use below. 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.
TD’s P/E of 14 is higher than its industry peers (12.9), which implies that each dollar of TD’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 8 Banks companies in CA including Laurentian Bank of Canada, Canadian Imperial Bank of Commerce and Bank of Nova Scotia. You could think of it like this: the market is pricing TD as if it is a stronger company than the average of its industry group.
Assumptions to watch out for
However, it is important to note that our examination of the stock is based on certain assumptions. The first is that our “similar companies” are actually similar to TD. If not, the difference in P/E might be a result of other factors. For example, if The Toronto-Dominion Bank is growing faster than its peers, then it would deserve a higher P/E ratio. We should also be aware that the stocks we are comparing to TD may not be fairly valued. Just because it is trading on a higher P/E ratio than its peers does not mean it must be overvalued. After all, the peer group could be undervalued.
What this means for you:
Since you may have already conducted your due diligence on TD, the overvaluation of the stock may mean it is a good time to reduce 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 highly recommend you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for TD’s future growth? Take a look at our free research report of analyst consensus for TD’s outlook.
- Past Track Record: Has TD 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 TD’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 firstname.lastname@example.org.