TSR Inc (NASDAQ:TSRI) is trading with a trailing P/E of 32.6x, which is higher than the industry average of 30x. 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. 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 our latest analysis for TSR
Demystifying the P/E ratio
P/E is a popular ratio used for 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.
P/E Calculation for TSRI
Price-Earnings Ratio = Price per share ÷ Earnings per share
TSRI Price-Earnings Ratio = 4.45 ÷ 0.137 = 32.6x
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 want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as TSRI, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since TSRI's P/E of 32.6x is higher than its industry peers (30x), it means that investors are paying more than they should for each dollar of TSRI's earnings. Therefore, according to this analysis, TSRI is an over-priced stock.
A few caveats
However, before you rush out to sell your TSRI shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to TSRI. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with TSRI, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing TSRI to are fairly valued by the market. If this does not hold, there is a possibility that TSRI’s P/E is lower because our peer group is overvalued by the market.
What this means for you:
Are you a shareholder? 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 TSRI. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.