thyssenkrupp AG (XTRA:TKA) trades with a trailing P/E of 43.3x, which is higher than the industry average of 12.5x. Although some investors may jump to the conclusion that you should avoid the stock or sell if you own it, understanding the assumptions behind the P/E ratio might change your mind. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for thyssenkrupp
Breaking down 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.
Formula
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for TKA
Price per share = €22.61
Earnings per share = €0.522
∴ Price-Earnings Ratio = €22.61 ÷ €0.522 = 43.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as TKA, such as size and country of operation. 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.
At 43.3x, TKA’s P/E is higher than its industry peers (12.5x). This implies that investors are overvaluing each dollar of TKA’s earnings. As such, our analysis shows that TKA represents an over-priced stock.
Assumptions to be aware of
However, before you rush out to sell your TKA shares, 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 TKA. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared riskier firms with TKA, then investors would naturally value TKA at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with TKA, investors would also value TKA at a higher price since it is a higher growth investment. Both scenarios would explain why TKA has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing TKA to are fairly valued by the market. If this does not hold, there is a possibility that TKA’s P/E is higher because firms in our peer group are being undervalued by the market.
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 TKA. 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:
- Future Outlook: What are well-informed industry analysts predicting for TKA’s future growth? Take a look at our free research report of analyst consensus for TKA’s outlook.
- Past Track Record: Has TKA 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 TKA’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.