Tethys Oil AB (publ) (OM:TETY) is currently trading at a trailing P/E of 9.5x, which is lower than the industry average of 14.3x. While this makes TETY appear like a great stock to buy, 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. View our latest analysis for Tethys Oil
Breaking down the Price-Earnings 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.
P/E Calculation for TETY
Price-Earnings Ratio = Price per share ÷ Earnings per share
TETY Price-Earnings Ratio = $9.22 ÷ $0.969 = 9.5x
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 TETY, such as capital structure and profitability. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. TETY’s P/E of 9.5x is lower than its industry peers (14.3x), which implies that each dollar of TETY’s earnings is being undervalued by investors. As such, our analysis shows that TETY represents an under-priced stock.
Assumptions to be aware of
Before you jump to the conclusion that TETY is the perfect buying opportunity, it is important to realise that our conclusion rests on two assertions. Firstly, our peer group contains companies that are similar to TETY. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you compared lower risk firms with TETY, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing TETY to are fairly valued by the market. If this is violated, TETY’s P/E may be lower than its peers as they are actually overvalued by investors.
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 add more of TETY to your portfolio. 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 highly recommend you to complete your research by taking a look at the following: