Should You Be Tempted To Buy Telefónica SA (BME:TEF) Because Of Its PE Ratio?

This analysis is intended to introduce important early concepts to people who are starting to invest and want to better understand how you can grow your money by investing in Telefónica SA (BME:TEF).

Telefónica SA (BME:TEF) is trading with a trailing P/E of 12.9x, which is lower than the industry average of 16.9x. 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 deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View out our latest analysis for Telefónica

Demystifying the P/E ratio

The P/E ratio is one of many ratios used in 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.

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 TEF, 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 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.

TEF’s P/E of 12.9x is lower than its industry peers (16.9x), which implies that each dollar of TEF’s earnings is being undervalued by investors. Since the Telecom sector in ES is relatively small, I’ve included similar companies in the wider region in order to get a better idea of the multiple, which is a median of profitable companies of companies such as Euskaltel, and . As such, our analysis shows that TEF represents an under-priced stock.

Assumptions to be aware of

While our conclusion might prompt you to buy TEF 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 TEF. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you are inadvertently comparing lower risk firms with TEF, then TEF’s P/E would naturally be lower than its peers, since investors would value those with lower risk with a higher price. The other possibility is if you were accidentally comparing higher growth firms with TEF. In this case, TEF’s P/E would be lower since investors would also reward its peers’ higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing TEF to are fairly valued by the market. If this assumption does not hold true, TEF’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.

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 TEF. 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 urge you to complete your research by taking a look at the following:

1. Future Outlook: What are well-informed industry analysts predicting for TEF’s future growth? Take a look at our free research report of analyst consensus for TEF’s outlook.
2. Past Track Record: Has TEF 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 TEF'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.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.