This article is intended for those of you who are at the beginning of your investing journey and want to begin learning about how to value company based on its current earnings and what are the drawbacks of this method.
Public Joint Stock Company Territorial Generation Company No 14 (MCX:TGKN) is trading with a trailing P/E of 18x, which is higher than the industry average of 6x. 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 break down what the P/E ratio is, how to interpret it and what to watch out for.
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as 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 TGKN
Price per share = RUB0.0052
Earnings per share = RUB0.000290
∴ Price-Earnings Ratio = RUB0.0052 ÷ RUB0.000290 = 18x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ultimately, our goal is to compare the stock’s P/E ratio to the average of companies that have similar attributes to TGKN, such as company lifetime and products sold. 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.
TGKN’s P/E of 18x is higher than its industry peers (6x), which implies that each dollar of TGKN’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. As such, our analysis shows that TGKN represents an over-priced stock.
A few caveats
However, before you rush out to sell your TGKN shares, it is important to note that this conclusion is based on two key assumptions. The first is that our peer group actually contains companies that are similar to TGKN. 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 TGKN, then TGKN’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 TGKN. In this case, TGKN’s P/E would be higher since investors would also reward TGKN’s higher growth with a higher price. The second assumption that must hold true is that the stocks we are comparing TGKN to are fairly valued by the market. If this does not hold, there is a possibility that TGKN’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 TGKN. 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 TGKN’s future growth? Take a look at our free research report of analyst consensus for TGKN’s outlook.
- Past Track Record: Has TGKN 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 TGKN’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 email@example.com.