This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Public Joint-Stock Company TNS energo Rostov-on-Don (MCX:RTSB) is currently trading at a trailing P/E of 24.3x, which is higher than the industry average of 5.9x. While this makes RTSB 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. 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.
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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for RTSB
Price per share = RUB0.32
Earnings per share = RUB0.0132
∴ Price-Earnings Ratio = RUB0.32 ÷ RUB0.0132 = 24.3x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to RTSB, 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 similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
RTSB’s P/E of 24.3x is higher than its industry peers (5.9x), which implies that each dollar of RTSB’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Electric Utilities companies in RU including Territorial Generation Company No.2, Volgogradenergosbyt and Rosseti. Therefore, according to this analysis, RTSB is an over-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that RTSB should be banished from your portfolio, 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 RTSB. 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 riskier firms with RTSB, then RTSB’s P/E would naturally be higher than its peers since investors would reward its lower risk with a higher price. The other possibility is if you were accidentally comparing lower growth firms with RTSB. In this case, RTSB’s P/E would be higher since investors would also reward RTSB’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing RTSB to are fairly valued by the market. If this assumption does not hold true, RTSB’s higher P/E ratio may be because firms in our peer group are being undervalued by the market.
What this means for you:
You may have already conducted fundamental analysis on the stock as a shareholder, so its current overvaluation could signal a potential selling opportunity to reduce your exposure to RTSB. 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:
- Future Outlook: What are well-informed industry analysts predicting for RTSB’s future growth? Take a look at our free research report of analyst consensus for RTSB’s outlook.
- Past Track Record: Has RTSB 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 RTSB’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.