True Grit Resources Ltd (TSXV:TGI.H) is currently trading at a trailing P/E of 24.2x, which is higher than the industry average of 10.3x. While this makes TGI.H appear like a stock to avoid or sell if you own it, 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. See our latest analysis for True Grit Resources
What you need to know about the P/E ratio
The P/E ratio is a popular ratio used in relative valuation since earnings power is a key 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 TGI.H
Price per share = CA$0.05
Earnings per share = CA$0.002
∴ Price-Earnings Ratio = CA$0.05 ÷ CA$0.002 = 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. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to TGI.H, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll 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.
TGI.H’s P/E of 24.2x is higher than its industry peers (10.3x), which implies that each dollar of TGI.H’s earnings is being overvalued by investors. As such, our analysis shows that TGI.H represents an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your TGI.H shares immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to TGI.H. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with TGI.H, then investors would naturally value TGI.H at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with TGI.H, investors would also value TGI.H at a higher price since it is a higher growth investment. Both scenarios would explain why TGI.H has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing TGI.H to are fairly valued by the market. If this assumption is violated, TGI.H’s P/E may be higher than its peers because its peers are actually undervalued by investors.
What this means for you:
If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to rebalance your portfolio and reduce your holdings in TGI.H. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned 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:
- Financial Health: Is TGI.H’s operations financially sustainable? Balance sheets can be hard to analyze, which is why we’ve done it for you. Check out our financial health checks here.
- Past Track Record: Has TGI.H 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 TGI.H’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.